Category Archives: new hedge fund regulations

Barney Frank to Hedge Funds: See You on November 12th

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As we’ve previously noted, Congress is chomping at the bit to regulate hedge funds.  An article in the New York Times yesterday regarding hedge fund managers opposing mortgage modifications “outraged” the House Financial Services Committee.  Because of this “irresponsible” and “antisocial” behavior, Congress has summoned the funds mentioned in the NYT article to a hearing on November 12th.  The tone of the Congressional announcement is definately antagonistic, something that the hedge fund industry does not need at this time.  The press release, reprinted below, can also be found here.

For Immediate Release: October 24, 2008

Chairmen Frank, Kanjorski, Maloney, Waters, Gutierrez and Watt Demand Hedge Funds Drop Opposition to Foreclosure Prevention

November 12th Financial Services Committee Hearing Announced

Washington, DC – House Financial Services Committee Chairman Barney Frank (D-MA), along with Capital Markets, Insurance and Government Sponsored Enterprises Subcommittee Chairman Paul E. Kanjorski (D-PA), Financial Institutions and Consumer Credit Subcommittee Chairwoman Carolyn Maloney (D-NY), Housing and Community Opportunity Subcommittee Chairwoman Maxine Waters (D-CA), Domestic and International Monetary Policy Trade and Technology Chairman Luis Gutierrez (D-IL), and Oversight and Investigations Subcommittee Chairman Melvin Watt (D-NC), expressed their “outrage” at the report in the New York Times today that at least two hedge funds have warned companies servicing mortgages they should not take advantage of a bill passed by Congress and signed by the President aimed at reducing the rate of foreclosure:

“What Congress passed overwhelmingly and President Bush signed last July provides for a reasonable modification of mortgages that clearly never should have been granted in the first place to avoid foreclosure and thus lessen the economic damage that a cascade of foreclosures has been doing to our economy.  In drafting this legislation, we consulted with a wide range of consumers, industry, and government regulatory groups, and we believe we adopted a reasonable proposal. Indeed, we have been criticized by some in the consumer community for not doing more to pressure institutions to avoid foreclosure while minimizing their losses.  In light of this, we were outraged to read that two hedge funds, Greenwich Financial Services and Braddock Financial Corporation, are instructing the servicers of their mortgages to defy this national program and to insist on further socially and economically damaging foreclosures. We believe the law clearly allows for modification where such changes would involve a lesser loss than foreclosure, and the benefits to the whole economy of such an approach are obvious.”

“For hedge funds, which have been the beneficiary of a lack of regulations and a very permissive attitude, now to put obstacles in the way of this important national policy is intolerable.  We have written to these two hedge funds and to the Managed Funds Association as well, strongly urging them to reverse this policy which will have such negative impacts on the economy.  Because this is so important, and because this irresponsible, antisocial behavior by these hedge funds has such important implications, we have set a hearing of the Financial Services Committee for November 12, and we are inviting these companies as well as the Managed Funds Association to attend.  If we are not able to get voluntary attendance, then we will pursue steps to compel them.

“Many in the financial community have objected to the argument many of us have made that homeowners should be allowed to invoke the protection of the bankruptcy laws on single family residences, as they are on second and third homes.  The argument in the financial community has been not only that this would be damaging, but that it would not be necessary to achieve the economically desirable result of reduced foreclosures.  But the decision of these two companies actively to oppose our efforts to achieve voluntary compliance quickly undercut that argument, and people in the financial community should not be surprised if this sort of blatant refusal to show any cooperation whatsoever with our efforts leads to an increased demand for much tougher legislation.”

Other related HFLB articles include:

The Beginning of Hedge Fund Regulation…

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As much as it is despised by all in the industry, it is likely that hedge fund regulation will be coming to the U.S.  Today the House Oversight Committee interviewed three very important regulations as part of an examination into the role of federal regulators in the current financial crisis.  Congress will interview Former Federal Reserve Chairman Alan Greenspan, Former Treasury Secretary John Snow and SEC Chairman Christopher Cox.  Hopefully these three will be able to stem the rising tide of hedge fund regulation rhetoric and help congress to realize that hedge funds are not the problem.

From the House website:

Committee Holds Hearing on the the Role of Federal Regulators in the Financial Crisis
Table of Contents

The Committee is holding a hearing titled, “The Financial Crisis and the Role of Federal Regulators” at 10:00 a.m. on Thursday, October 23, 2008, in 2154 Rayburn House Office Building. The hearing will examine the roles and responsibilities of federal regulators in the current financial crisis.

From the SEC website:

Chairman Christopher Cox to Testify

Chairman Cox will testify before the House Committee on Oversight and Government Reform on Thursday, October 23, 2008, at 10:00 a.m. at the Rayburn House Office Building, Room 2154, concerning “The Role of Federal Regulators”.

Previous SEC Testimony to Congress Regarding Hedge Funds

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As noted in an earlier post, I have started a new section which will deal with the potential for new hedge fund regulations.  In order to get an idea of where we might be headed, I have looked backed to see what the SEC has said to Congress about hedge funds previously.  Below is a transcript of Susan Ferris Wyderko’s testimony before a Senate Subcommittee.  Some of the more interesting parts of this speech include:

  • background of hedge fund industry
  • hedge fund regulation
  • hedge fund fiduciary obligation
  • cases against fraudulent hedge fund managers
  • discussion of prime brokerage

Please note that the discussion on investment advisor registration for hedge fund managers is no longer accurate thanks to Phillip Goldstein of Bulldog Investors who successful challenged the SEC’s registration rule. The link for this testimony can be found here.

Testimony Concerning Hedge Funds

by Susan Ferris Wyderko
Director, Office of Investor Education and Assistance
U.S. Securities & Exchange Commission
Before the Subcommittee on Securities and Investment of the
U.S. Senate Committee on Banking, Housing, and Urban Affairs
May 16, 2006

Chairman Hagel, Ranking Member Dodd, and Members of the Subcommittee:

I. Introduction

Thank you for inviting me to testify today about hedge funds, the role they play in our securities markets, and the Commission’s role in their oversight. The Commission has a substantial interest in the activities of hedge funds and their advisers, which only recently have become major participants in our securities markets.

The Commission recognized the growing importance of hedge funds almost four years ago when it directed the staff of the Division of Investment Management to undertake a fact-finding mission aimed at reviewing the operation and practices of hedge funds and their advisers. That review led to the publication by the Commission of a staff report entitled “Implications of the Growth of Hedge Funds,” in which the staff described in detail the organization of the hedge fund industry, its growth, and regulation.1

While identifying a number of concerns and making several policy recommendations, the report also described the many benefits hedge funds provide investors and our national securities markets. They contribute substantially to market efficiency, price discovery and liquidity. By actively participating, for example, in markets for derivative instruments, hedge funds can help counterparties reduce or manage their own risks, thus reducing risk assumed by other market participants. Moreover, many hedge funds provide an important risk management tool for institutional investors wishing to allocate a portion of their portfolio to an investment with low correlation to overall market activity.2

II. Background

Hedge funds are pools of investment capital that are managed by professional investment advisers and that are not offered generally to the public. They are operated so that they are not subject to the same regulatory requirements of mutual funds, which are governed by the Investment Company Act of 1940 which contains many safeguards for retail investors. Hedge funds are not characterized by a single dominant investment strategy, although many seek to obtain returns that are not correlated to market returns and instead seek to obtain an “absolute return” in a variety of market environments. Some adopt a “multi-strategy” approach that permits the adviser to determine, at any given time, what investment strategy to follow to pursue returns for the investors. Hedge funds also do not have a single risk profile. Some utilize leveraging techniques that expose investors to substantial risks, while others adopt investment strategies more similar to mutual funds.

Hedge funds do, however, share some organizational characteristics that distinguish them from most mutual funds. Most are organized by advisers that retain a substantial equity participation in the fund, and who receive compensation based, in large part, upon gains achieved by the fund (a “performance fee”). A typical fee arrangement will pay the adviser two percent of the total amount of assets under management and 20% of both realized and unrealized gains. Hedge fund managers view these fee structures as better aligning their interests with the interests of their investors and providing substantial incentives for good performance.

Hedge fund managers usually have a great deal of flexibility in managing the fund, which permits them to take advantage of market opportunities that may not be available to other types of institutional investors. They can change investment strategies, trade rapidly, and utilize leveraging techniques not permitted to mutual funds. And, in contrast to mutual funds, which must disclose publicly their portfolio holdings quarterly, many hedge funds do not even disclose portfolio holdings to all of their investors. Hedge fund advisers do, however, often offer disclosure to their investors about the extent and flexibility of their investment strategies.

1. Growth and Significance of Hedge Funds

The ability of some hedge fund managers to generate significant returns has attracted a great deal of investor interest. It is estimated that hedge funds today have more than $1.2 trillion dollars of assets, a remarkable growth of almost 3,000% in the last 16 years.3 In 2005, an estimated 2,073 new hedge funds opened for business.4 One report recently projected that assets of hedge funds may grow to $6 trillion by 2015.5

Much of the growth of hedge funds is attributable to increased investment by institutions, such as private and public pension plans, endowments and foundations.6 Many of these investors sought out hedge funds during the recent bear markets in order to address losses from traditional investments.

The ability of hedge fund managers to sustain above-market returns is a matter of some debate, as is the likelihood that hedge funds as an asset class will continue to grow.7 Nonetheless, hedge funds play and will likely continue to play an important role in the securities markets, the significance of which exceeds the amount of their assets. Although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume.8 They are highly active in the convertible bond and credit derivatives markets. Moreover, hedge funds are becoming more active in the markets for corporate control,9 private lending, and crude petroleum. Their activities affect all Americans directly or indirectly.

2. Application of the Federal Securities Laws

Press articles typically refer to hedge funds as “lightly regulated” investment pools. In a sense, they are correct. As noted above, hedge funds are organized and operated so that they are not subject to the Investment Company Act of 1940. In addition, hedge funds issue securities in “private offerings” that are not registered with the Commission under the Securities Act of 1933, and hedge funds are not required to make periodic reports under the Securities Exchange Act of 1934. However, hedge funds are subject to the same prohibitions against fraud as are other market participants, and their managers have the same fiduciary obligations as other investment advisers.

III. The Commission’s Oversight of Hedge Fund Activities

The Commission’s oversight responsibilities with respect to hedge fund activities generally fall into three principal areas: fiduciary obligations; market abuse; and risks to broker-dealers. Each is described below.

1. Fiduciary Obligations

Hedge fund managers are “investment advisers” under the Investment Advisers Act of 1940. As a result, a hedge fund manager owes the fund and its investors a fiduciary duty that requires the manager to place the interests of the hedge fund and its investors first, or at least fully disclose any material conflict of interest the manager may have with the fund and its investors. Hedge fund advisers have this fiduciary obligation as a matter of law regardless of whether they are registered with the Commission.

The Advisers Act provides the Commission with authority to enforce these obligations, which the Commission has exercised vigorously in order to protect investors. Over the past several years the Commission has brought a number of enforcement cases against hedge fund advisers who have violated their fiduciary obligations to their hedge funds and investors. These cases involve advisers who have engaged in misappropriation of fund assets; portfolio pumping; misrepresenting portfolio performance; falsification of experience, credentials and past returns; misleading disclosure regarding claimed trading strategies; and improper valuation of assets. In some cases we have worked with criminal authorities.

Recent examples of significant cases brought by the Commission include:

* SEC v. Samuel Israel III; Daniel E. Marino; Bayou Management, LLC et al. The Commission alleged that the advisers of a Connecticut-based group of hedge funds defrauded investors in the funds and misappropriated millions of dollars in investor assets for their personal use. Over $450 million was raised from investors. The advisers issued fictitious account statements to investors and used a sham accounting firm to forge audited financial statements in order to hide substantial losses. These losses resulted from, among other things, the theft of funds by the advisers who withdrew “incentive fees” to which they were not entitled. On September 29, 2005, the Commission filed an action in U.S. District Court seeking injunctions, disgorgement of ill-gotten gains, prejudgment interest, and civil money penalties.10 Also on that date, Israel and Marino pleaded guilty in a companion criminal case. They have not yet been sentenced. On April 19, 2006, the defendants in the civil case consented to an order permanently enjoining them from future violations of the antifraud statutes of the federal securities laws.11

* SEC v. Sharon E. Vaughn and Directors Financial Group, Ltd. The Commission alleged that an Illinois hedge fund adviser registered with the Commission defrauded fund investors by improperly investing fund assets in a fraudulent “prime bank” trading scheme contrary to the fund’s disclosed trading strategy. According to the Commission’s complaint, the adviser and its principal had an undisclosed profit sharing agreement with one of the trading program promoters. The adviser and principal consented to injunctions and agreed to disgorgement of over $800,000.12 As a result of the SEC’s action and a subsequent criminal action brought by the U.S. Attorney’s office involving individuals associated with the trading program, hedge fund investors were returned most of their principal investment and profits prior to investment in the trading program.

a. New Registration Requirement

Until recently, registration with the Commission was optional for many hedge fund advisers. In February of this year, new rules became effective that require that most hedge fund advisers register with the Commission under the Advisers Act.13 The new rules do not regulate hedge fund strategies, risks or investments. The new rules have given the Commission basic census data about hedge fund advisers. In addition, registration has required hedge fund advisers to implement compliance programs to prevent, detect and correct compliance violations and to designate a chief compliance officer to administer each adviser’s compliance program. Registration also has provided the Commission authority to conduct compliance examinations of registered hedge fund advisers. Based upon registration data we now know that 24% of the 10,000 investment advisers currently registered with the Commission advise at least one hedge fund. Of the 2,456 hedge fund advisers registered with us as of the end of April, 1,179 (45%) registered in response to the new rule.14 The vast majority of the hedge fund advisers (88%) registered with the Commission are domiciled in the United States.

b. Examinations

As mentioned above, registered hedge fund advisers may be subject to on-site compliance examinations by SEC examiners in the Office of Compliance Inspections and Examinations (OCIE). The SEC maintains a risk-based examination program, and determines which firms to examine based on their risk characteristics. Hedge fund advisers have been included in the same pool as other registered advisers, and thus, like other advisers, the staff determines which firms to examine based on the compliance risks the firm presents to investors. Examination staff are working with the Division of Investment Management and Office of Risk Assessment to develop improved metrics to assess the compliance risks of registered advisers in order to continue to focus our exam resources. In addition, OCIE has developed a specialized training program to better familiarize examiners with the operation of hedge funds and thus improve the effectiveness of our examination of hedge fund advisers.

During a routine compliance examination, the staff reviews the effectiveness of the compliance controls that every registered investment adviser must have in place to prevent or detect violations of the federal securities laws. In those areas where controls appear to be weak, our examiners will obtain additional information to determine if the weak control environment has resulted in a violation of the securities laws. The staff also reviews disclosure documents, including any private placement memoranda provided to hedge fund investors, to determine whether the disclosure appears to accurately reflect the hedge fund adviser’s management of the fund. In addition, the staff identifies areas of potential conflicts of interest with respect to the hedge fund adviser and the fund that it advises to determine whether appropriate disclosure has been made.

It is the staff’s experience that many of the compliance issues raised by an adviser’s management of a hedge fund are similar to those raised by other advisers’ asset management activities. For example, these compliance issues include: the use of soft dollar arrangements, the allocation of investment opportunities among clients, the valuation of securities, the calculation of performance, and the safeguards over customers’ assets and non-public information. In this regard, let me identify a few areas in which we plan to focus our examinations of hedge fund advisers:

Side-by-Side Management. Some hedge fund managers also advise other types of advisory accounts, including mutual funds.15 Because the adviser’s fee from the hedge fund is based in large measure on the fund’s performance-and because the adviser typically invests heavily in the hedge fund itself, this “side-by-side” management presents significant conflicts of interest that could lead the adviser to favor the hedge fund over other clients. The staff will focus on whether the hedge fund manager appears to have sufficient controls in place to prevent such bias and whether, in fact, the adviser has favored its hedge funds over other clients.

Side Letter Agreements. Side letters are agreements that hedge fund advisers enter into with certain investors that give the investors more favorable rights and privileges than other investors receive. Some side letters address matters that raise few concerns, such as the ability to make additional investments, receive treatment as favorable as other investors, or limit management fees and incentives. Others, however, are more troubling because they may involve material conflicts of interest that can harm the interests of other investors. Chief among these types of side letter agreements are those that give certain investors liquidity preferences or provide them with more access to portfolio information. Our examination staff will review side letter agreements and evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to other investors.

Valuation of Fund Assets. A hedge fund manager typically values the assets of the hedge fund using the market value of those securities. When the fund holds publicly traded securities, that process is fairly simple. Many hedge funds, however, own thinly traded securities and derivative instruments whose valuation can be very complicated and, in some cases, highly subjective. Unlike a mutual fund, hedge fund valuation practices are not overseen by an independent board of directors. A number of the Commission’s enforcement cases against hedge fund advisers involve the adviser’s valuation of fund assets in order to hide losses or to artificially boost performance. Thus, a review of valuation policies and practices is a key element of hedge fund adviser examinations.

Custody of Fund Assets. A hedge fund manager typically has access to and directs the use of fund assets. Such access presents a significant risk to fund investors — as demonstrated in a number of the Commission’s enforcement actions involving theft or misuse of fund assets by a hedge fund manager. Therefore, Commission examiners focus attention on the controls used to protect fund assets.

2. Market Abuse

Hedge fund advisers’ active trading plays an important role in our capital markets. The federal securities laws and Commission regulations establish rules designed to prevent market abuses. When market activity by hedge fund advisers-like any other participant in the securities markets-crosses the line and violates the law, the Commission has taken appropriate remedial action. In the past year, the Commission has brought enforcement actions against hedge fund advisers for a variety of market abuses, including insider trading, improper activities in connection with short sales, market manipulation, scalping, and fraudulent market timing and late trading of mutual funds.

Recent significant cases have included:

* In the Matter of Millennium Partners, L.P., Millennium Management, L.L.C., Millennium International Management, L.L.C., Israel Englander, Terence Feeney, Fred Stone, and Kovan Pillai. The Commission brought an action against hedge fund managers alleging that the managers generated tens of millions of dollars in profits for their hedge funds through deceptive and fraudulent market timing of mutual funds at the expense of the mutual funds and their shareholders. The adviser and its principals agreed to disgorgement and civil monetary penalties, and have undertaken to implement particular compliance, legal, and ethics oversight measures.16

* SEC v. Hilary Shane. The Commission alleged a particular type of insider trading involving a PIPE transaction, where the hedge fund adviser agreed to buy shares of a public company in a private offering – a transaction that the Commission alleged was likely to have a significant dilutive effect on the value of the company’s shares – and then misused information she had been given (and which she had agreed to keep confidential) about the private offering by short-selling the company’s shares. The adviser agreed to disgorge the trading profits, paid a civil penalty, and has consented to be barred from the broker-dealer industry and suspended from the investment advisory industry.17

* SEC v. Scott R. Sacane, et al. The Commission alleged that hedge fund advisers manipulated the market by creating the appearance of greater demand for two stocks than actually existed. The individual defendants in this case have both pled guilty to related criminal charges and have been barred by the Commission from associating with an investment adviser. In addition, one of the defendants has agreed to pay disgorgement and a civil penalty in the Commission’s civil action, which remains pending against the other defendants.18

Not only has the Commission brought enforcement actions against the hedge funds and hedge fund advisers that engage in these transactions, it has brought actions against fund service providers who facilitated these unlawful securities trading activities. Recently, for example, we settled an enforcement action against a large broker-dealer that helped hedge funds foil the efforts of mutual funds to detect the hedge funds’ market timing, and made it possible for certain favored hedge fund clients to “late trade” mutual fund shares.19

3. Risks to Broker-Dealers

Hedge funds can (although we understand many do not) make significant use of leverage. Most hedge funds use one or more “prime brokers,” which provide clearing and related services to the fund and its adviser. One core service prime brokers offer their hedge fund customers is secured financing, notably margin lending, where the hedge fund borrows from the prime broker in order to buy securities, which then serve as collateral for the loan.20

The Commission continues to focus attention on broker-dealers’ exposure to hedge fund risks and the broader implications this aspect of the financial system may have. The Commission staff meets regularly with other members of the President’s Working Group on Financial Markets, and works with the industry members that comprise the Counterparty Risk Management Policy Group. In addition, the Commission’s consolidated supervision program for certain investment banks now allows the staff to examine not only the broker-dealer entities within a group, but also the unregulated affiliates and holding company where certain financing transactions with hedge funds are generally booked. Commission staff meets at least monthly with senior risk managers at these broker-dealer holding companies to review material risk exposures, including those resulting from hedge fund financing and those related to sectors in which hedge funds are highly active.

IV. Looking Forward

As a result of our recently-implemented hedge fund adviser registration rulemaking, the Commission now has more data about hedge funds and their advisers. The staff is in the process of evaluating those data and considering methods to refine its ability to target our examination resources by more precisely identifying those advisers, including hedge fund advisers, that pose greater compliance risks.

In addition, the Commission staff is working with the United Kingdom’s Financial Services Authority, to coordinate policy and oversight of the 165 hedge fund advisers registered with the Commission that are located in the United Kingdom. The staff also expects to coordinate examinations with the Commodity Futures Trading Commission (CFTC). To that end, we recently provided information to the CFTC indicating the identities of hedge fund advisers registered with the Commission who report on their registration forms that they are also actively engaged in commodities business (approximately 350 firms).

V. Conclusion

In conclusion, I would like to thank the Subcommittee for holding this hearing on a subject of growing importance to us and to all American investors. Hedge funds play an important role in our financial markets. With respect to hedge funds, their advisers and all market participants, the Commission will continue to enforce vigorously the federal securities laws.

Endnotes

1 Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (Sept. 2003), available at http://www.sec.gov/news/studies/hedgefunds0903.pdf.

2 A recent study reported that 78% of institutional investors surveyed said that hedge funds reduced the volatility of their portfolio. State Street Corporation, Hedge Fund Research Study (Mar. 2006) at 4.

3 See Hedge Fund Research, HFR Q1 2006 Industry Report.

4 See Hedge Fund Research, HFR Q1 2006 Industry Report. During 2005, 848 funds were liquidated. Id.

5 Van Hedge Fund Advisers, International, LLC, Hedge Fund Demand and Capacity 2005-2015 (Aug. 2005).

6 See Hennessee Group, 2004 Hennessee Hedge Fund Survey of Foundations and Endowments (reporting that the investors surveyed had an average commitment of 17% of assets, and a projected commitment of 19% by 2005).

7 See Nicholas Chan, Mila Getmansky, Shane M. Haas, and Andrew W. Lo, “Systemic Risk and Hedge Funds,” (Aug. 1, 2005) (unpublished manuscript, to appear in M. Carey and R. Stulz, eds., The Risks of Financial Institutions and the Financial Sector, Chicago, IL: University of Chicago Press).

8 See Pam Abramowitz, “Trade Secrets,” Institutional Investor’s Alpha, January/February 2006.

9 Mara Der Hovanesian, “Attack of the Hungry Hedge Funds,” Business Week (Feb. 2006); Henry Sender, “Hedge Funds: The New Corporate Activists–Investment Vehicles Amass Clout In Public Firms, Then Demand Management Boost Share Price,” The Wall Street Journal (May 13, 2005).

10 Litigation Release No. 19406 (Sept. 29, 2005).

11 Litigation Release No. 19692 (May 9, 2006).

12 Litigation Release No. 19589 (Mar. 3, 2006).

13 The Commission’s recent rulemaking required certain hedge fund advisers to register as investment advisers with the Commission under the Investment Advisers Act of 1940, under which registration previously had been optional for many hedge fund advisers. Commissioners Glassman and Atkins dissented from the rulemaking. Registration Rule at 72089. With respect to the management of hedge funds whose advisers are registered with the Commission, the Commission in adopting the adviser registration requirement observed that, “The [Advisers] Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments.” Registration Rule at section II.A. [Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 2004), 69 FR at 72060, petition for review filed (D.C. Cir. No. 04-1434 (argued Dec. 9, 2005). (“Registration Rule”).]

14 Registration forms indicate that these advisers report just over 13,000 hedge funds with aggregate assets of about $2 trillion. Because reported assets include assets of “feeder” funds as well as “master” funds in which they invest, total reported assets likely are higher than if assets of “feeder” funds were excluded.

15 Almost 15% (379) of the hedge fund advisers registered with the Commission report that they also advise at least one mutual fund.

16 Investment Advisers Act Release No. 2453 (Dec. 1, 2005).

17 Litigation Release No. 19227 (May 18, 2005). Because she entered into the short sales prior to the effective date of the registration statement for the PIPE and then covered her short sales with those she obtained in the PIPE offering, the Commission also alleged that Ms. Shane violated section 5 of the Securities Act.

18 Litigation Release No. 19424 (Oct. 12, 2005). See also In the Matter of Scott R. Sacane, Investment Advisers Act Release No. 2483 (Feb. 8, 2006); In the Matter of J. Douglas Schmidt, Investment Advisers Act Release No. 2491 (Feb. 28, 2006); SEC v. Scott R. Sacane, et al., Litigation Release No. 19515 (Dec. 22, 2005); SEC v. Scott R. Sacane, et al., Litigation Release No. 19605 (Mar. 9, 2006).

19 In the Matter of Bear, Stearns & Co., Inc., and Bear, Stearns Securities Corp., Securities Act Release No. 8668 (Mar. 16, 2006) (defendants agreed to censure, payment of disgorgement and civil monetary penalties, and have undertaken to implement particular compliance oversight measures).

20 Prime brokers may also structure these financing transactions as repurchase agreements, where they buy the securities from the hedge fund subject to the fund’s obligation to repurchase the securities from the broker in the future at a specified price. Prime brokers may also produce similar economics through the use of over-the-counter derivative contracts with hedge funds.

New Hedge Fund Regulations – SEC to Conduct Roundtable Today

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As I’ve mentioned previously we can expect tighter regulations in the coming months for the financial services industry in general and the hedge fund industry specifically.  To track these changes I’ve instituted a new section entitled new hedge fund regulations which I will keep updated with information.

Below the SEC is taking the first steps to decide how to move forward in this new world financial order through a series of panel discussions.  The SEC is also soliciting comments from the financial services industry on a variety of questions.  These steps are obviously necessary and should be productive if the SEC really listens to the practitioners from the industry.  The release can be found here.

SEC Roundtable on More Transparent Disclosure to Address Lessons of Current Credit Crisis
FOR IMMEDIATE RELEASE
2008-241

Washington, D.C., Oct. 7, 2008 — The Securities and Exchange Commission today announced the agenda for Wednesday’s roundtable on providing more transparency to investors that will include discussion of lessons from the current credit crisis. Among other issues, panelists will address better ways to explain complex financial instruments to investors and the marketplace, and will propose ways to provide investors with more transparent, useful, and timely access to high-quality information. The roundtable is part of the SEC’s 21st Century Disclosure Initiative (www.sec.gov/disclosureinitiative) that is fundamentally rethinking disclosure.

Panel One: The Market’s Use of Disclosure Information and the SEC’s Disclosure System

This panel will explore whether the current system of collecting and filing data for SEC disclosure obligations has kept pace with the market. It will examine how investors can get all the information they need to make increasingly complex investment decisions. It will also consider the data, technology, and processes that companies and other filers use in satisfying their SEC disclosure obligations. The panel will compare the needs and uses of investors and companies to the capabilities of the SEC’s disclosure system in an effort to better understand any gaps and inefficiencies that can lead to inaccuracies, delays, and unnecessary complexity.

  • John Bajkowski, Vice President and Senior Financial Analyst, American Association of Individual Investors
  • Robert Sorrentino, Director of Accounting Policy and External Reporting, Xerox Corp.
  • David Copenhafer, former Director of EDGAR Services, Bowne & Co., Inc.
  • Glenn Doggett, Policy Analyst, CFA Institute Centre for Financial Market Integrity
  • Paul Haaga, Jr., Vice Chairman, Capital Research and Management Co.
  • Kara Jenny, Chief Financial Officer, Bluefly, Inc.
  • Timothy Thornton, Principal, Web Services, The Vanguard Group, Inc.

Panel Two: Modernizing the SEC’s Disclosure System

This panel will consider how the SEC could better organize and operate its disclosure system so that investors could have better access to high-quality information and companies could enjoy efficiencies. In particular, the panel will discuss ways to structure disclosure data so investors can more effectively search for company data and compare investment options. The panel will describe a possible “company file system,” in which core company information would be collected in a central structured data file, and will also discuss other approaches that harness technology to better serve investors and the markets.

  • Alan Beller, Partner, Cleary Gottlieb Steen & Hamilton LLP
  • Steven Bochner, Partner, Wilson Sonsini Goodrich & Rosati
  • Esther Dyson, Chairman, EDventure Holdings
  • Joseph Grundfest, Professor of Law, Stanford Law School
  • Eric Roiter, Lecturer on Law, Harvard University Law School and Boston University School of Law
  • Liv Watson, Member, Board of Directors, IRIS
  • Hillary Sale, Chair in Corporate Finance and Law, University of Iowa College of Law
  • Douglas Chia, Senior Counsel and Assistant Corporate Secretary, Johnson & Johnson

Moderators:

  • John White, Director of SEC’s Division of Corporate Finance
  • Andrew Donohue, Director of SEC’s Division of Investment Management
  • Jim Kaput, Counsel to 21st Century Disclosure Initiative
  • Matthew Reed, Assistant Director of 21st Century Disclosure Initiative

The SEC’s roundtable will be held on Wednesday, October 8 in the auditorium of the SEC’s Washington D.C. headquarters at 100 F Street, NE from 9 a.m. until approximately 1 p.m. The roundtable will be open to the public on a first-come, first-served basis. It will be webcast live on the SEC’s Web site, and an archived version of the webcast will later be available for free download.

The Commission welcomes feedback regarding any of the topics to be addressed at the roundtable, and has issued a formal request for public comment. The Commission is particularly interested in comments responding to these questions:

General Issues

  1. Should the Commission make changes to its current forms-based disclosure system? Please explain why or why not.
  2. What are the key issues to be considered in the review of the Commission’s disclosure system? Are particular aspects of the system and process especially useful and well executed, and are particular aspects especially in need of improvement?
  3. What are the purposes of issuer disclosure from the perspective of investors, filers, and regulators?

Specific Issues

The Market’s Use of Disclosure Information

  1. How do operating and investment companies collect, summarize, analyze, file, and disseminate the information that is submitted to the Commission?
  2. How do operating and investment companies submit disclosure and reporting information to the Commission? How have these methods changed during the last 15 years, particularly after filing via EDGAR was fully implemented? How could the Commission’s system be changed to reduce burdens and create efficiencies, consistent with investor protection?
  3. How do investors retrieve and use the disclosure information that companies submit to the Commission? How could this information be better presented, and more easily retrieved and used through technological improvements?
  4. What disclosure information that companies submit to the Commission is used by investors to make investment decisions? Is any information that companies submit to the Commission not used? What information that is not required to be filed or furnished with the Commission do investors and others use to make investment decisions or give investment advice?

The Commission’s Current Disclosure Syste

  1. Does the Commission’s current disclosure system present difficulties? What difficulties can be attributed to technological problems? Which can be attributed to regulatory or statutory problems?

Modernizing the Commission’s Disclosure System

  1. How should the Commission’s disclosure system be modernized? One possibility is a company file system. What alternative systems should be considered? What different or additional benefits might these alternatives provide?
  2. How should a modern disclosure system, such as a company file system, be organized, and how could it improve the way disclosure information is submitted and used?
  3. What features should any modernized disclosure system provide in order to serve the needs of filers, investors, regulators, and other users of information? Why? Data tagging using XBRL, or eXtensible Business Reporting Language, is one way, but we understand there are other ways to structure data. What alternative ways could be used by companies to submit structured data to the Commission?
  4. What are the costs and benefits to investors and other market participants of structuring non-financial disclosures, including, for example, data tagging?
  5. What time frame would be appropriate for implementing a company file system?
  6. What benefits and costs to preparers and users of information would accompany the implementation of modernized disclosure system, such as a company file system, that requires all, or virtually all, data to be filed in a structured format? Would such a system be more useful to some investors, such as small or less sophisticated investors? Would some investors be harmed by such a system? Would larger companies benefit more than smaller companies? Would costs fall disproportionately on one group of companies?
  7. Are any changes to the Commission’s disclosure regulations required for a transition to a company file system? How could these changes be identified?

The information that is submitted for comment will become part of the public record of the roundtable. All submissions received will be posted without change. The SEC does not edit personal identifying information from submissions. Only information desired to be shared publicly should be submitted.

Congress Targets Aggressive Tax Positions by Offshore Hedge Funds

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After my first year of law school I was a legal intern for a company which sold products to lawyers.  The CEO was a former tax attorney and on multiple occasions told me with pride that “tax attorneys are the brain surgeons of the law.”  Whatever he meant by that, it has been apparent throughout my career that tax attorneys are certainly important and that almost every issue will, in some way, involve taxes.  This is especially true with regard to the investment management industry and hedge funds specifically.

Congress has become more keen on reigning in aggressive tax positions by hedge funds, specially offshore hedge funds.  The republished statements by Senator Carl Levin below details transactions used by some offshore hedge funds, including swap transactions and stock loans, in order to avoid payment of taxes on dividends.  The statements below provide an overview of the transactions, while the accompanying report, which can be found here, provides more in depth reporting on the transactions.  The release can be found here.

It is likely we will hear more about this as discussions of hedge fund regulation continues.  We saw last year there was a popular movement toward eliminating the performance allocation for publicly traded hedge fund companies and for hedge fund companies in general (see HR 2834).  The speech below also shows that Congress is aware of aggressive tax practices of some offshore hedge funds.  While these are two different issues (the former is a policy issue and the later is an enforcement issue), they signal that Congress is ready to attack hedge funds on all fronts.

Please let us know if you have any questions.

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FOR IMMEDIATE RELEASE
September 11, 2008
Contact: Press Office
Phone: 202.228.3685

Opening Statement of Senator Carl Levin U.S. Senate Permanent Subcommittee on Investigations Hearing on Dividend Tax Abuse: How Offshore Entities Dodge Taxes on U.S. Stock Dividends

One of the problems that this Subcommittee has tackled in recent years is the stunning fact that each year, the United States loses perhaps $100 billion in tax revenues to offshore tax havens that aid and abet corporations and wealthy individuals dodging payment of taxes owed to Uncle Sam.

Since 2001, we have examined this problem from multiple angles, exposing the ways that people use tax havens to hide their assets and income, and how tax havens have created a whole industry to help them exercise control over their offshore assets and use those assets and the revenues they produce for their own benefit, often sneaking funds back into the United States without paying the taxes owing. Just two months ago, in July, this Subcommittee held a hearing showing how banks in those offshore tax havens have knowingly helped U.S. clients hide billions of dollars in secret bank accounts never reported to the IRS.

Today, our spotlight is on another facet of tax haven abuses: we call it dividend tax abuse. And the focus today is not on U.S. citizens, but on non-U.S. persons who are supposed to be paying taxes on the dividends they receive from U.S. corporations, but don’t. They don’t pay those taxes, because major financial institutions like Lehman Brothers, Morgan Stanley, Deutsche Bank, UBS, Merrill Lynch, Citigroup, and others have created financial gimmicks whose primary purpose to enable clients to dodge U.S. taxes owed on U.S. stock dividends, but which are dressed up with phrases like “dividend enhancement,” “yield enhancement,” and even “dividend uplift.” Using stock swaps, stock loans, and exotic financial instruments, the financial institutions have built a series of financial black boxes, surrounded by mind-numbing complexity, designed to keep their clients’ money tax-free.

Foreigners who invest in the United States already enjoy a minimal tax burden. For example, non-U.S. persons who deposit money with a U.S. bank or securities firm pay no U.S. taxes on the interest earned. They pay no U.S. taxes on capital gains. U.S. citizens do pay taxes on that income, but the tax code lets foreign investors operate without tax in an effort to attract foreign investment.

But there is one tax on the books that even foreign investors are supposed to pay. If they buy stock in a U.S. company, and that stock pays a dividend, the non-U.S. stockholder is supposed to pay a tax on the dividend. The general tax rate is 30%, unless their country of residence has negotiated a lower rate with the United States, typically 15%.

In addition, to make sure those dividend taxes are paid, U.S. law requires the person or entity paying a stock dividend to a non-U.S. person to withhold the tax owed Uncle Sam before any part of the dividend leaves the United States. If the “withholding agent” fails to retain and remit the dividend tax to the IRS, and the tax is not paid by the dividend recipient, the tax code makes the withholding agent equally liable for the unpaid taxes.

That’s the law. But the reality is that many non-U.S. stockholders never pay the dividend taxes they owe. In 2003, the latest year for which data is available, the Government Accountability Office determined that about $42 billion in dividend payments were sent abroad, but less than 5%, or $2 billion, was sent to the IRS. In other words, billions of dollars left the country untaxed.

The Subcommittee’s investigation has determined that part of the reason for unpaid dividend taxes is that, for more than ten years, U.S. financial institutions have been helping non-U.S. clients dodge payment.

Listen to this roll call of well known financial institutions. Morgan Stanley enabled its clients to dodge payment of $300 million in U.S. dividend taxes from 2000 to 2007. Lehman Brothers estimated that in one year alone, 2004, it helped clients dodge perhaps $115 million in U.S. dividend taxes. For UBS, the figure is $62 million in unpaid dividend taxes over a four-year period, 2004 to 2007. One hedge fund adviser, Maverick Capital, calculated that, from 2000 to 2007, its offshore funds used so-called “dividend enhancement” products from multiple firms to escape dividend taxes totaling nearly $95 million. In 2007, Citigroup surprised the IRS by paying $24 million in unpaid dividend taxes on a select group of swap transactions from 2003 to 2005, where no dividend taxes had been paid.

Who were the clients? Hedge funds organized offshore, often by Americans; tax haven banks; and a host of sophisticated foreign investors with the means and the know-how to engage in financial transactions beyond the reach of ordinary folks. But that’s not the whole story. Some of those foreign investors begin to look a lot less foreign once you take a closer look.

I’m referring in particular to so-called “offshore” hedge funds. When the Subcommittee began contacting them, all of their key personnel turned out to be here in the United States. The so-called “offshore” hedge funds’ main offices were here in the United States; their key decisionmakers were here; their investment professionals and technical people live here. Most of these offshore hedge funds claim to be located in the Cayman Islands. The Cayman Islands, in fact, have 10,000 hedge funds, more than any other country in the world. But the Cayman hedge funds we examined did not operate in any meaningful sense from the Caymans. Instead, their physical presence often amounted to little more than a Cayman post office box or a plaque on the wall of the infamous Ugland House, that small white building where more than 18,000 companies maintain a Cayman address.

Hedge funds run by Americans and invested in the U.S. stock market often create a shell of a presence in tax havens, presumably in part to avoid paying U.S. taxes. Then, when confronted by the one U.S. tax imposed on foreign investors receiving U.S. stock dividends, they turn to financial gymnastics to escape paying that tax as well. It adds insult to injury when hedge fund managers who live in the United States, enjoy all its benefits, protections and prosperity, and use U.S. markets to make money, arrange tax dodges so their offshore hedge funds escape the minimal U.S. tax obligations they are supposed to pay.

Hedge funds and other offshore entities couldn’t perform their dividend tax escape act without the cooperation and assistance of financial institutions. It is those financial institutions that devise the abusive transactions and send the U.S. dividend payments offshore to their clients in the form of dividend equivalent or substitute dividend payments, without remitting any taxes to the U.S. Treasury. Their own emails show that they took those actions knowingly to attract and retain clients and to profit from the fees. With their assistance, billions of dollars in U.S. dividends flowed out of this country, and very few taxes were withheld.

I want to take a moment here to explain two of the most common schemes used to dodge dividend taxes. They involve swaps and stock loans. In both cases, financial sleight of hand is used to recast taxable dividend payments as untaxable transfers offshore.

Swap Transaction. First consider swaps. Swaps sound complicated, but they are essentially a financial bet, in this case a bet on the future of a stock price.

Take a look at this chart. It shows an offshore hedge fund in blue, which is controlled by a U.S. investment manager in green. The financial institution, shown in red, tells the hedge fund – which owns U.S. stock – that it can escape the 30% withholding tax on an upcoming stock dividend by purporting to sell the stock to the financial institution and simultaneously entering into a swap with the financial institution tied to the price of that stock.

Under the swap, the financial institution promises to pay the hedge fund an amount equal to any price appreciation in the stock price and the amount of any dividend paid during the term of the swap. The payment reflecting the dividend is a “dividend equivalent.” In return, the hedge fund agrees to pay the financial institution an amount equal to any price depreciation in the stock price. The financial institution hedges its risk by holding the physical shares of stock that were “sold” to it by the hedge fund. It also charges a fee, which usually includes a portion of the tax savings that the hedge fund will obtain by dodging the withholding tax.

The swap gives the hedge fund the same economic risks and rewards that it had when it owned the physical shares of the stock. So why do it? Because under the tax code, dividend payments are taxed, but dividend equivalent payments made under a swap are not.

Dividend equivalent payments made under a swap are tax free, because in 1991, the IRS issued a series of regulations to determine what types of income will be treated as coming from the United States and therefore taxable. These so-called “source” rules treat U.S. stock dividends as U.S. source income, because the money comes from a U.S. corporation. But the 1991 regulation takes the opposite approach with respect to swaps. It deems swap agreements to be “notional principal contracts” and says that the “source” of any payment made under that contract is to be determined, not by where the money came from, but by where it ends up. In other words, the payment’s source is the country where the payment recipient resides.

That approach turns the usual meaning of the word, “source, “ on its head. Instead of looking to the origin of the payment to determine its “source,” the IRS swap rule looks to its end point — who receives it. That “source” is not really a “source” by any known definition of the word. It is the opposite – not the point of origin but the end point.

The result is that when a financial institution makes a dividend equivalent payment to an offshore client under a swap agreement, the tax code provides that the payment is from an offshore “source.” So the swap payment is free of any U.S. tax. In our example, the U.S. financial institution makes the swap payment to the offshore hedge fund, minus its fee, and stiffs Uncle Sam for the amount of taxes that should have been sent to the IRS. The swap is then terminated, and the stock is “sold” back to the hedge fund. Under this gimmick, the hedge fund ends up in the same position as before the swap, as a stockholder, except it has pocketed a dividend payment without paying any tax.

Stock Loan. Stock loans are also used to dodge dividend taxes. These transactions pile a stock loan on top of a swap to achieve the same tax-free result.

The first step is that the client with an upcoming dividend loans its stock to an offshore corporation controlled by the financial institution. This offshore corporation promises, as part of the loan agreement, to forward any dividend payments back to the client.

The next step is that offshore corporation enters into a swap with the financial institution that controls it, referencing the same type of stock and number of shares that is the subject of the stock loan. Essentially, two related parties are placing a bet on the stock, which makes no economic sense except, once that stock pays the dividend, the swap arrangement allows the financial institution to send it as a tax-free dividend equivalent payment to the offshore corporation it controls. The offshore corporation then forwards the same amount to the client. Because the payment is sent to the client as part of a stock loan agreement, it is called a “substitute dividend.” The tax code treats substitute dividends in the same way as the underlying dividend. So if the underlying dividend came from a U.S. corporation, the substitute dividend would normally be taxed as U.S. source income.

But in this transaction, the parties claim the substitute dividend is tax-free by invoking the wording of an obscure IRS Notice 97-66 never intended to be applied to this situation. That notice says that when two parties in a stock loan are outside of the United States and subject to the same dividend tax rate, they don’t have to pay the dividend tax when passing on a substitute dividend. The assumption is that the tax was already paid by another party in the lending transaction. Some tax lawyers have seized on the wording to claim that this IRS Notice, which was intended to prevent overwithholding, could be used to eliminate dividend withholding entirely, so long as one offshore party passes on a substitute dividend to another offshore party subject to the same dividend tax rate. The IRS told the Subcommittee that Notice 97-66 was never intended to be interpreted that way, but in the ten years since it was issued and abusive stock loans have exploded, the IRS has never put that in writing.

The end result in our example is that the client pockets a substitute dividend payment – minus the financial institution’s fee – without paying any tax. The stock loan is terminated, and the stock is returned to the client. The big advantage of this approach over a swap, is that the client doesn’t have to explain why he got his stock back after the transaction. The stock was, after all, only on loan. Tax avoidance was clearly the economic purpose of the two transactions just described. The client owned U.S. stock both before and after each transaction. Neither the swap nor the stock loan altered the client’s market risk. The only risk involved in either transaction was that Uncle Sam would catch on and assess the dividend taxes that should have been paid but weren’t. To make it harder for Uncle Sam to catch on and prove what is going on, financial institutions have added more complexity, more bells and whistles, to their transactions. But the purpose of the transactions remains the same – to enable clients to escape paying the taxes they owe.

And it’s clear that the participants knew their transactions were little more than tax dodging. In one email exchange about a proposed stock loan, a potential client informed Merrill Lynch that its tax counsel had said “the transaction works, as I said, once, maybe twice,” but “repeated use, coincidentally around dividend payment time, would provide a strong case for the IRS to assert tax evasion.” Another client explaining a Lehman swap transaction to a colleague wrote that the swap “is used to circumvent the tax.” That’s the unvarnished truth. The participants in these transactions also took steps to limit their exposure in case the IRS stepped in. Some of the financial institutions, for example, set an annual limit on the amount of unpaid dividend taxes that they would facilitate through their transactions, to limit their exposure as withholding agents. Some of the clients demanded that the financial institutions indemnify them against any tax liability. A few financial institutions, such as UBS, Merrill Lynch, and Morgan Stanley, have stopped offering the most blatantly abusive transactions, while others have continued doing as many deals as ever.

Some may claim that, by exposing this tax dodging and being determined to end it, we are trying to discredit structured finance or the financial markets. But I support financial transactions used for legitimate purposes, including swaps and stock loans that facilitate capital flows, reduce capital needs, or spread risk. What I oppose is the misuse of financial transactions to undermine the tax code, rob the U.S. treasury, and force honest Americans to shoulder the country’s tax burden. What I oppose are transactions whose patent economic purpose is tax dodging. For the last ten years, as dividend tax dodging took hold and became an open secret among market insiders, the U.S. Treasury Department and the IRS sat on their hands. When firms began claiming they could turn taxable dividend payments into untaxed dividend equivalents under swaps, Treasury and the IRS said nothing. When firms began claiming that the 1997 IRS notice designed to cure overwithholding could eliminate all withholding in offshore stock loans, Treasury and the IRS failed to issue corrective guidance. When firms openly advertised so-called “dividend enhancement” products to clients, Treasury and the IRS saw nothing, heard nothing, and took no enforcement action.

The government’s failure to act does not in any way excuse the actions of the financial institutions or their clients. They are not saved from their own abusive conduct by the failure of regulators to stop them, any more than going through a red light is okay if you’re not caught. Nonetheless, the silence and inaction of the Treasury and IRS in the face of rampant dividend tax dodging has encouraged and continues to encourage financial institutions to offer their clients financial concoctions designed to enable them to dodge U.S. dividend taxes. It is past time to end that silence, end that inaction, and get those concoctions off the market. It is also past time for Congress to take on this billion-dollar offshore tax abuse and, like so many others, enact the legislation needed to put a stop to it.

I want to thank my Ranking Member, Senator Coleman, for his support of this investigation and invite him to make opening remarks.