In the conversations the hedge fund community will be having with Congress and the regulators in the coming months regarding increased regulation, we should look to shared answers to the issues which need to be addressed. In this vein, I have been researching the speeches of prominent SEC personel. I have just recently reviewed a speech by former Commissioner Paul Atkins regarding regulations and how regulations impact the investment management community. Perhaps surprising to some, the former Commissioner showed reasonably thinking with regard to increased regulation.
The speech, reprinted in its entirety below, was given in the wake of the proposed adoption of two rule changes back in December of 2006. The first proposed rule change was to amend the Investment Advisers Act so that it was clear that hedge fund managers had an anti-fraud duty to the investors in their hedge funds as well as the hedge funds themselves. The second proposed rule was the “accredited natural person” rule which would effectively change the potential make up of hedge funds by requiring a different net worth threshold for investors in hedge funds. There were a significant amount of comments to the proposed rules which stated that it would be a bad idea to raise the net worth requirements for hedge fund investors. Neither of the proposed rules have been adopted and it is unlikely that they will be, at least in the near future.
With the new rules in the background the speech below highlights many important notes which Congress, regulators and the hedge fund community should consider when discussing any new possible regulations. I have chosen a few good quotes, but the whole speech is worth reading.
On reasonable hedge fund regulation:
“The regulatory environment is one of the factors that influences the flow of capital. A regulatory decision that is innocuous on its own may “break the camel’s back” when bundled on top of other existing regulations. Regulations can be beneficial, but they are almost never costless.”
“We need to be mindful that the marginal benefit that a new regulation promises may justify the rule, but the costs of adding another rule to the rulebook should not be ignored. The answer is smart regulation: Do not adopt new rules unless they can pull their own weight. The aggregate burden matters.”
On making sure that future regulations take into consideration the needs of the small advisor or the smaller hedge fund manager:
“A much broader issue is the overall regulatory burden on small advisors, who after all dominate the landscape. IAA’s July 2006 profile of the investment advisory profession13 notes that ninety percent of SEC-registered advisors have fifty or fewer employees. In addition to considering the effect of regulation on these existing small businesses, we need to consider the effect on potential new entrants to the industry. Ease of entry is a critical component of a healthy marketplace.”
“And, small advisors are feeling the increasing regulatory burden. A four-person “plain vanilla” advisor sent me its compliance calendar to give me a sense of the time that it spends meeting various compliance obligations. The checklist of over 100 items makes one wonder how there is time left to manage money. Because of the regulatory and administrative costs inherent in taking on a new client, is it any wonder that one of the most frequent issues that I hear from individual investors when I am on the road doing investor education presentations, as I have done for 4½ years now, is that they cannot find reputable investment advisors who will take new accounts with smaller amounts of money to invest.”
Speech by SEC Commissioner:
Remarks Before the Investment Adviser Association
Commissioner Paul S. Atkins
U.S. Securities and Exchange Commission
April 27, 2007
Thank you, David, for your kind introduction and for all of the constructive commentary that the Investment Adviser Association provides to the SEC. I will discuss some of that today. It is an honor and a pleasure to be here at the close of your conference. I actually am a bit surprised that the Texas State Troopers allowed me to disembark from my plane to be here. After all, I grew up in Florida, cheering at many a Gator football game, and all these Longhorns probably do not take too kindly to being displaced by Gators. Gators, of course, are in the SEC … a different one than the one with which I am affiliated now.
I hope that in-between seminars, you all have had a chance to explore a little bit of Austin. In addition to the legendary live music and a vibrant high-tech sector, I understand that Austin also offers some impressive natural phenomena, such as the famous Texas wildflowers and the city’s 1.5 million bats that come out for dinner at dusk. I assume that they are not vampires and prey only on mosquitoes and insects. David, maybe you had better take a roll call of the participants to make sure that you have as many as you started out with. Although my talk does not feature live music, live flowers, or live bats, I will share a few thoughts on some of the live issues at the SEC. I also would be interested in hearing what issues are on your minds. Before I go on any further, I should say that the views I express here are my own and do not necessarily reflect those of the Securities and Exchange Commission or my fellow Commissioners.
Back in Washington, much of the recent debate has been about a series of reports on the state of the U.S. capital markets. These reports remind us that regulatory decisions matter to the economy as a whole, not just to the affected individual market participants. The regulatory environment is one of the factors that influences the flow of capital. A regulatory decision that is innocuous on its own may “break the camel’s back” when bundled on top of other existing regulations. Regulations can be beneficial, but they are almost never costless. These reports thus serve as a needed reminder of the effects – good and bad — that regulation can have on our capital markets.
In addition to these broader questions, the reports raise some interesting issues at the micro-level. Specifically relevant to this audience is the recommendation related to the SEC’s Office of Compliance Inspections and Examinations (OCIE). The report that was prepared by the Commission on the Regulation of U.S. Capital Markets in the 21st Century, under the sponsorship of the U.S. Chamber of Commerce, recommended that the SEC “realign its organizational structure to improve its efficiency and mirror the contours of the current capital markets, including, for example, by folding [OCIE] back into the operating divisions to facilitate consistent interpretations of applicable rules.” Concerns about the apparent lack of communication between OCIE and the Divisions of Investment Management and Market Regulation underlie this recommendation.
It is a big job for our examiners to try to oversee the thousands of broker-dealers, investment advisors, and investment companies that are registered with the SEC, to say nothing of transfer agents, stock exchanges, and now the Public Company Accounting Oversight Board’s own inspection program of accountants. The staff faces a constant challenge to keep up with the growing number of registered entities that it oversees. The Government Accountability Office has pointed this out to us on a number of occasions, and in fact is currently undertaking a review of how we manage OCIE and the enforcement division.
Some of you may have experienced personally an apparent disconnect between those who write rules and those who examine regulated entities. Perhaps, a deficiency letter that you received required you to take an action that is neither in the statutes nor in SEC regulations. In a letter sent last year, the IAA noted an instance in which an OCIE examiner directed an advisor to set a specific gift threshold in its code of ethics. The examiner determined this threshold. It is a good idea to have a gifts policy, but there is no requirement to that effect, and the Commission has not set any thresholds.
Sometimes OCIE’s demands are based on staff guidance, but staff guidance is not equivalent to a Commission rule. In one recent example that I saw, a broker-dealer’s recommendations were judged unsuitable because they failed to conform with an OCIE-generated list of suitability criteria. Setting these sorts of criteria is a role that the NASD appropriately plays, and perhaps an area for Commission rulemaking after notice and comment, but not for ad-hoc determination by individual examiners in the field.
Of the more than 1,300 advisor exams conducted by OCIE in 2006, eighty-one percent resulted in deficiency letters. Given that ratio, it seems that a letter is just about par-for-the-course. Putting the worst light on these letters, some might say that the industry is in a parlous state. But, of course, most of the findings in these letters can be classified as very technical in nature — for example, failing to put an ID number on a continuation page of Form ADV. Putting the best light on these letters, one could say that it is like consulting – our examiners see many types of firms and practices, and their comments can add value or catch budding problems before they become major trouble. Ideally, too, the things that our examiners see in the field can help inform our regulatory divisions back in Washington. We only have to point to the market timing problems than the mutual fund industry had a few years ago to see how the SEC can do this better. Whether it is merely better internal communications that are needed or a new management or organizational structure is an issue that this Commission faces. Thus, perhaps we should take the IAA’s suggestion and call these letters “reports of examination.”
Deficiency letters are not the only way in which OCIE can impose extra-regulatory requirements; speeches sometimes have the effect of imposing new requirements. One concern of mine is Rule 206(4)-7, the compliance rule. Suggestions have been made, for example, that advisors need to provide OCIE with a laundry list of compliance breaches. Even more of a stretch, it has been suggested that the list extend to contemplated, but rejected, actions that might have led to compliance breaches. These types of requirements can have precisely the opposite effect than what is intended. The compliance officer becomes shut out of internal discussions because people become afraid to consult with him on anything, lest they get on a list to be produced to the government for raising in good faith a new idea or a question regarding applicable law or regulation. That, after all, is why a firm has a compliance officer in the first place!
Many problems with existing recordkeeping rules for advisors arise in connection with OCIE exams. Our staff has focused increasingly on emails and other electronic messages, which can provide important insight into what is going on at a firm. The intensified interest in email, however, has proven frustrating and costly for firms. Some firms have complained that the staff’s email requests go beyond the scope of the records that the rules require them to keep. Even if firms have copies of the requested emails, they incur substantial costs in searching for and producing them within the deadlines set by the staff. These concrete costs might be dwarfed by lost efficiencies and impeded customer service if firms elect to stop or curtail email usage in order to avoid having the burden of complying with staff requests. Our staff needs to look at emails as part of its examinations, but we owe firms clear guidance on what electronic messages they need to keep, how they need to keep them, and how long they need to keep them.
Because of this uncertainty with the recordkeeping requirements as well as other issues, should we be surprised that 488 hedge fund advisors have withdrawn from SEC registration since the hedge fund advisor registration requirement was vacated? I hope that the revisions to our recordkeeping rules, which are now underway, will help to address these problems.
Additional steps are being taken to provide more guidance. OCIE, which is now 600-strong, is implementing new examination tools to achieve greater consistency across examinations. OCIE maintains an examination hotline for registrants who have a question, complaint, or concern about an SEC examination. Hotline calls can be made anonymously. I certainly also would be happy to serve as a back-up hotline, and our conversation could be not for attribution to give you an additional measure of comfort. Another positive step is OCIE’s “Anti-Money Laundering (AML) Source Tool,” which is on the SEC website. It compiles key AML laws, rules, and guidance applicable to broker-dealers. This guidance is an example of how OCIE can help firms to stay out of trouble rather than merely catching them when they get into trouble. Another example is the CCOutreach program, which offers chief compliance officers useful assistance in doing their jobs. Because this is a joint project with the Division of Investment Management, it also helps to address concerns about intra-agency communication.
Ultimately, of course, the buck stops with the Commission as to how it organizes, runs, and manages its examination function, including setting priorities, training examiners, determining proper conduct and procedures for those examiners, and judging success of the program (because you get what you measure). Most importantly, regulations should be written in a manner that does not encourage the addition of supplemental requirements during examinations and enforcement actions.
Some have suggested that the antifraud portion of the hedge fund rule that we proposed at the end of last year could do just that. This is proposed Rule 206(4)-8(a)(2), to be precise, which would outlaw any investment advisor to any pooled investment vehicle to “engage in any act, practice, or course of business that is fraudulent, deceptive, or manipulative with respect to any investor or prospective investor”.
One commenter expressed concern that “the lack of clarity in the Proposed Rule may lead to Staff interpretations that do not have the benefit of the formal rule-making process.” Some commenters have raised questions about our statutory authority to adopt Rule 206(4)-8 because of its open-ended nature and its lack of a scienter requirement. These concerns deserve meaningful SEC consideration, particularly in light of the SEC’s recent losses in the U.S. Court of Appeals.
We have received more negative comment on the accredited investor portion of the hedge fund proposal than the antifraud proposal. Under the accreditation proposal, a natural person must meet both the current accredited investor standard and in addition own $2.5 million or more in certain investments before being allowed to invest in a hedge fund.
Many commenters see the SEC’s proposal as putting their dream of attaining wealth a little further out of reach. U.S. Trust released earlier this month its annual study of affluent Americans, defined as those with “investable net worth greater than $5 million, not including primary residence.” Eighty-four percent of those surveyed stated that they had started out “from scratch and became wealthy only later in life.” Most Americans share a common dream of doing just that – starting with nothing and ending up wealthy, through hard work, investing wisely, luck, and taking risks. Our proposal stuck in these investors’ philosophical craw, as reflected in this comment:
The idea that only the rich are sophisticated enough to know the risks is such elitist, un-American thinking that the SEC should be ashamed of having created the first set of limits. Big Brother is alive and well in the SEC.
We should remember that other investments would not carry these additional up-front barriers. One commenter noted that there are no restrictions on buying a government-sponsored lottery ticket. Now, to the extent that one considers a lottery ticket an investment, the risk of losing your entire investment is pretty high. The lottery, which is viewed by many as a form of entertainment rather than an investment, may not really be a fair comparison. But what about venture capital funds, which enjoy for now a special carve-out from the proposed accredited natural person requirements? What about other private placements? What about penny stocks?
Other commenters, including the IAA, recommended an exception from the accredited natural person standard for accredited investors who hire an investment advisor. An investor without sufficient knowledge and sophistication could pay someone more knowledgeable and sophisticated than he to manage his money. Now, of course, one could say that you all have every interest to make this suggestion, since advisors would gain a valuable government-sanctioned gatekeeper role for non-accredited investors. That being said, the suggestion is consistent with at least part of the historical justification for accredited investor standards. Wealth and financial sophistication do not always go hand-in-hand, but people with more money can seek someone out to help them manage it. Dr. Phil, whom Forbes reported as having earned $45 million from June 2005 to June 2006, may give good advice on interpersonal relationships, but perhaps needs someone to provide him with investment advice. Maybe that also explains why the 22-year old Cleveland Cavs star, multi-millionaire LeBron James, recently has been spotted with Warren Buffett.
Commenters pointed out a number of other modifications that could allay concerns about the accredited natural person standard. Not raising the threshold so high is one obvious possibility. That would be a less sweeping change from the status quo. The Managed Funds Association (MFA), which has long recommended increasing investment thresholds for hedge funds, objected to the SEC’s proposal. The MFA recommended simply adjusting the existing income and net worth standards for inflation. The existing amounts were set back in 1982 and have not been modified since. Under this approach, the revised numbers would be lower than under the proposed rule – an inflation-adjusted $1 million net worth requirement in 1982 dollars would be approximately $1.9 million today. One additional wrinkle is whether personal residences would be excluded. The approach since 1982 included their value, but our proposal excludes them from the calculation of net worth.
The SEC can also take steps to address some practical concerns about the operation of the rule. Commenters asked the SEC to make it easier for more employees of advisors to private pools to invest in those pools. Doing so would provide investors the comfort of knowing that the employees are committed to the success of the fund. It also could help private funds to retain good employees.
Another concern is that the proposed rule would not allow existing investors to be grandfathered. In other words, current private fund investors who do not meet the new standard would not be permitted to make future investments, even in funds in which they currently are invested. We asked and received comment on the issue. Many commenters urged the inclusion of a grandfather clause to allow investors to make follow-on investments in private funds.
Regardless of what we do, the proposed rule, by its very nature, will have some unintended consequences. For example, the magnitude of the proposed change causes me to worry, along with a commenter, that there will be “a rush by funds to close transactions prior to effectiveness, thereby putting undue pressure on investors and possible worsening the situation that the SEC hopes to remedy.” 
One reason for my concern about getting the accredited natural person threshold right is the implications that the rule will have on small advisors. Regardless of what the thresholds are, the big name advisors will be able to attract investor money. New and start-up funds will bear the brunt of the regulatory limitations on investor eligibility. Commenters raised this concern.
A much broader issue is the overall regulatory burden on small advisors, who after all dominate the landscape. IAA’s July 2006 profile of the investment advisory profession13 notes that ninety percent of SEC-registered advisors have fifty or fewer employees. In addition to considering the effect of regulation on these existing small businesses, we need to consider the effect on potential new entrants to the industry. Ease of entry is a critical component of a healthy marketplace.
And, small advisors are feeling the increasing regulatory burden. A four-person “plain vanilla” advisor sent me its compliance calendar to give me a sense of the time that it spends meeting various compliance obligations. The checklist of over 100 items makes one wonder how there is time left to manage money. Because of the regulatory and administrative costs inherent in taking on a new client, is it any wonder that one of the most frequent issues that I hear from individual investors when I am on the road doing investor education presentations, as I have done for 4½ years now, is that they cannot find reputable investment advisors who will take new accounts with smaller amounts of money to invest.
Congress has directed agencies like the SEC to consider ways to accomplish particular regulatory objectives with the smallest possible adverse effect on small entities. Unfortunately, this analysis does not focus on the collective impact of our regulations, although it does direct us to consider whether there are duplicative rules. We need to be mindful that the marginal benefit that a new regulation promises may justify the rule, but the costs of adding another rule to the rulebook should not be ignored. The answer is smart regulation: Do not adopt new rules unless they can pull their own weight. The aggregate burden matters.
Let us take one example on the mutual fund side. Small mutual funds struggle to attract enough investors to survive in the shadow of the well-known names that dominate the market. The highly regulated environment in which they seek to compete makes their struggle more difficult. Yet in the fund governance rulemakings that have distracted us for the past several years, the SEC has relied more on the positive feelings that the word “independent” generates than on a real consideration of costs and benefits. Central to that consideration are the effects of this now-vacated government mandate on small funds. Costs go beyond the direct costs of paying independent directors. There are also the indirect costs on small advisors who have invested their time, money, and effort to start a fund based on an innovative, new approach. By deterring entrepreneurs, who would have to recruit someone willing to be an independent chairman of a start-up fund, among other things, we would deprive investors of opportunities and choices. Small funds pointed this out to us in their comment letters. One commenter put it this way:
There are very real costs associated with the Independent Chair Rule and the 75% Independent Board Members Rule. Each additional cost on its own may not seem large, but when combined with other costs of the increased regulatory environment, these costs become larger for small fund complexes.
I am pleased to report that the SEC under Chairman Cox is taking steps regarding the rising costs of regulation. For example, I think that we are going in a positive direction with respect to Section 404 of the Sarbanes-Oxley Act. As you know, Section 404 requires management to complete an annual internal control report and requires the company’s auditor to attest to, and report on, management’s assessment. I spoke to you last year about the grave implementation problems associated with Section 404. We are working with the Public Company Accounting Oversight Board to change the manner in which the section is implemented so that it allows our economy to reap the intended benefits without the high costs that have characterized it so far. We also are working with other regulators on a wide range of issues from hedge funds to 401(k) plan disclosure. Collaboration among regulators lessens the burdens on regulated entities. I am pleased to note that Buddy Donohue, head of our Division of Investment Management, has recently announced that he and his staff are embarking on a review of the regulations that have accumulated on our books to determine which to keep and which to eliminate.
When I spoke to you exactly one year ago, the SEC had just suffered the second judicial rejection of our fund governance rule. Since then, we have continued to keep the courts busy. Our hedge fund registration mandate was thrown out, and, just last month, the D.C. Federal Circuit Court of Appeals rejected another one of our rules, the so-called “BD/IA rule.” The rule excepted from the Advisers Act broker-dealers providing advice that is solely incidental to brokerage, but charging an asset-based or fixed fee for its services. Unlike the other decisions, this was a split decision, and the Court found that the SEC had exceeded its authority. The dissenting judge found the SEC’s interpretation of the Advisers Act to be “a reasonable interpretation of an ambiguous statute.”
I certainly think that the SEC would be well justified to ask for this ruling to be heard by the full DC Circuit – unlike the other vacated rules, this rule was adopted by a unanimous Commission. At the very least, as an interim measure, we need to ask the Court for a stay to allow for an orderly transition and appropriate rulemaking consistent with the Court’s decision. Otherwise, I am afraid of confusion in the marketplace. Now that many firms have shifted customers into fee-based accounts in reliance on our actions — and, one could argue, at our strong urging — we should be striving to provide as much certainty as is in our power to provide to affected investors.
I would like briefly to discuss the bigger questions that are at issue and will have to be resolved. As you all know, there are strong feelings about where and how to draw appropriate lines between broker-dealer and investment advisory activities and regulatory regimes. In fact, just yesterday, the Consumer Federation of America and the Zero Alpha Group announced the results of an investor study on broker-advisor issues and concluded that the SEC “has been headed in the wrong direction in its regulation of financial professionals.”
The SEC recognized the difficult questions in this area and their far-reaching importance at the time it adopted the rule. Indeed, the adopting release announced that the staff would undertake a further examination of the broker-dealer and investment advisor regulatory regimes. Last September, the SEC commissioned the RAND Corporation to do the fact-gathering and empirical research that will form the basis for the SEC’s next steps in this area. RAND is looking at how financial products and services are marketed, sold, and delivered to retail investors. The study will investigate, among other things, how financial professionals are compensated and what investor perceptions are. This study will provide the raw material for the SEC’s further action in the area. It is encouraging that any regulatory action or legislative recommendations will be built on a solid factual basis.
This brings me back to where I began. The U.S. Chamber Report called for a fresh look at how OCIE structurally fits into the SEC structure. The issues that gave rise to the RAND study might lead to questions about how the Divisions of Investment Management and Market Regulation fit into the SEC structure. If we were building the SEC anew from the ground up in 2007, I think that it is reasonable to ask whether we would organize the SEC as it currently is structured. Might we instead have a division devoted to retail investor issues and another, perhaps based in New York, devoted to markets?
I look forward to hearing your thoughts on these and other issues. Thank you for your attention.
 Commission on the Regulation of the U.S. Capital Markets in the 21st Century, Report and Recommendations (Mar. 2007) at 6 (available at: http://www.capitalmarketscommission.com/portal/capmarkets/default.htm).
 Letter from Karen L. Barr, General Counsel of IAA, to Lori Richards, Director, OCIE at n. 10 (Mar. 29, 2006) (available at: http://www.investmentadviser.org/public/letters/comment032906.pdf)
 Remarks of Lori Richards Remarks at the 9th Annual IA Compliance Best Practices Summit 2007, IA Week and the Investment Adviser Association (Mar. 23, 2007) (available at: http://www.sec.gov/news/speech/2007/spch032307lar.htm).
 Comment Letter of Schulte, Roth & Zabel LLP (Mar. 9, 2007) (available at: http://www.sec.gov/comments/s7-25-06/s72506-549.pdf)
 U.S. Trust Survey of Affluent Americans (April 2007) at 1 (available at: http://www.ustrust.com/pdf/SurveyXXVI_Report.pdf).
 Id. at 8.
 Comment Letter of John F. Wallace (Jan. 27, 2007) (available at: http://www.sec.gov/comments/s7-25-06/jfwallace5042.htm).
 Comment Letter of Dennis Pike (Jan. 28, 2007) (available at: http://www.sec.gov/comments/s7-25-06/s72506-157.htm)
 See Comment Letter of the IAA (Mar. 9, 2007) (available at: http://www.sec.gov/comments/s7-25-06/s72506-530.pdf.)
 Lea Goldman and Kiri Blakeley, The Celebrity 100, Forbes.com (available at: http://www.forbes.com/2006/06/12/06celebrities_money-power-celebrities-list_land.html).
 Comment Letter of the Managed Funds Association (Mar. 9, 2007) (available at: http://www.sec.gov/comments/s7-25-06/s72506-567.pdf).
 Comment Letter of Wyrick, Robbins, Yates & Ponton LLP at 2 (Mar. 9, 2007) (available at: http://www.sec.gov/comments/s7-25-06/s72506-551.pdf).
 Investment Adviser Association and National Regulatory Services, Evolution Revolution 2006 (July 2006) (available at: http://www.icaa.org/public/evolution_revolution-2006.pdf).
 Comment Letter of Aquila Investment Management (Aug. 21, 2006) (available at: http://www.sec.gov/rules/proposed/s70304/s70304-504.pdf).
 Financial Planning Association v. Securities and Exchange Commission, 482 F.3d 481, 501 (D.C. Cir. 2007) (Garland, J., dissenting).
 Zero Alpha Group Press Release, As SEC Eyes Appeal of Court Ruling, ZAG/CFA Survey Shows Current Broker Disclosure is Not Working, Investors Favor Consistent Regulation of Stockbrokers, Advisors (Apr. 26, 2007) (available at: http://www.zeroalphagroup.com/news/042607_release.cfm).