Registration Under the Advisers Act of Certain Hedge Fund Advisers

See SEC v. Capital Gains Research Bureau, Inc., et al., 375 U.S. 180 (1963) (“Capital Gains”). See also Transamerica Mortgage Advisors, Inc., (TAMA) v. Lewis, 444 U.S. 11 (1979); Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 471, n. 11 (1977).

See Capital Gains, supra note 1, at 191-194.

See In the Matter of Kidder, Peabody & Co., Incorporated, Edward B. Goodnow, Investment Advisers Act Release No. 232 (Oct. 16, 1968); In the Matter of Mark Bailey & Co., and Mark Bailey, Investment Advisers Act Release No. 1105 (Feb. 24, 1988); In the Matter of Jamison, Eaton & Wood, Inc., Investment Advisers Act Release No. 2129 (May 15, 2003).

See supra note 3.

Section 203(b)(3) [15 U.S.C. 80b-3(b)(3)]. The Act also provides several other registration exemptions, which have much more limited application. Registration exemptions are provided to advisers that have only intrastate business and do not give advice on exchange-listed securities (section 203(b)(1) [15 U.S.C. 80b-3(b)(1)]); to advisers whose only clients are insurance companies (section 203(b)(2) [15 U.S.C. 80b-3(b)(2)]); to charitable organizations and their officials (section 203(b)(4) [15 U.S.C. 80b-3(b)(4)]); to church plans (section 203(b)(5) [15 U.S.C. 80b-3(b)(5)]); and to commodity trading advisors registered with the Commodity Futures Trading Commission (“CFTC”) whose business does not consist primarily of acting as investment advisers (section 203(b)(6) [15 U.S.C. 80b-3(b)(6)]).

They are also subject to antifraud provisions of other federal securities laws, including rule 10b-5 under the Securities Exchange Act of 1934 [17 CFR 240.10b-5].

Section 204 of the Advisers Act [15 U.S.C. 80b-4] authorizes the Commission to conduct examinations of all records of investment advisers. Records of advisers exempted from registration pursuant to section 203(b) of the Act [15 U.S.C. 80b-3(b)] are specifically excluded from being subject to these examinations.

See discussion, infra, in Section II.B.8. of this Release.

Id.; see also infra Section II.C of this Release.

See Definition of “Client” of an Investment Adviser for Certain Purposes Relating to Limited Partnerships, Investment Advisers Act Release No. 983 (July 12, 1985) [50 FR 29206 (July 18, 1985)] (“Rule 203(b)(3)-1 Adopting Release”). In 1997, we expanded the rule to cover other types of legal entities that advisers use to pool client assets. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR 28112 (May 22, 1997)] (“NSMIA Implementing Release”). Under rule 203(b)(3)-1(a)(2)(i)[17 CFR 275.203(b)(3)-1(a)(2)(i)], an investment adviser may count a legal organization as a single client so long as the investment advice is provided based on the objectives of the legal organization rather than the individual investment objectives of any owner(s) of the legal organization. Rule 203(b)(3)-1(b)(3)[17 CFR 275.203(b)(3)-1(b)(3)] states that “[a] limited partnership is a client of any general partner or other person acting as investment adviser to the partnership.” As discussed in more detail below, infra note 157, until we adopted this rule there was considerable uncertainty whether advisers to unregistered investment pools were required to look through the pools to count each investor as a client, or could count each pool as a single client.

See William Fung and David A. Hsieh, A Primer on Hedge Funds, 6 J. of Empirical Fin. 309-31(1999), at 310; David W. Frederick, Institute of Certified Financial Planners, Hedge Funds: Only the Wealthy Need Apply, Jan. 30, 1998, at http://www.yourretirement.com/fidlquest_22.htm (visited on Oct. 24, 2004); Roy Kouwenberg, Erasmus University Rotterdam & William T. Ziemba, Sauder School of Business, Vancouver and Swiss Banking Institute, University of Zurich, Incentives and Risk Taking in Hedge Funds, July 17, 2003, at http://www.few.eur.nl/few /people/kouwenberg/incentives3.pdf (visited on Oct. 24, 2004). See also Gregory Zuckerman, Hedge Funds Grab More In Fees As Their Popularity Increases, Wall St. J., Oct.8, 2004, at A1 (noting that some of the best-performing hedge fund advisers now receive between 30 and 50 percent of their funds' profits). Not all hedge funds, however, are managed by legitimate investment professionals. See SEC v. Ryan J. Fontaine and Simpleton Holdings Corporation a/k/a Signature Investments Hedge Fund, Litigation Release No. 18254 (July 28, 2003) (22 year-old college student purportedly acted as Signature's portfolio manager and made numerous false claims to investors and prospective investors).

See sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 [15 U.S.C. 80a-3(c)(1) and 3(c)(7)].

See Carol J. Loomis, Hard Times Come To The Hedge Funds, Fortune, Jan. 1970, at 10.

Bernstein Wealth Management Research, Hedge Fund Myths and Realities (Oct. 2002) at 3 (“[H]edge funds vary in many ways, including the broad array of strategies they employ, the manager's skill at implementing those strategies and the risks they take * * *”). See also Citigroup Asset Management, Strategic Thinking: What's In A Hedge Fund? Toward A Better Understanding Of Sources Of Returns (Apr. 2004) (examining 12 hedge fund strategies and challenging the view that hedge funds are all designed to deliver absolute returns).

Ted Caldwell, Introduction: The Model for Superior Performance, in Hedge Funds, Investment and Portfolio Strategies for the Institutional Investors, (Jess Lederman & Robert A. Klein eds., 1995); Julie Rohrer, The Red-Hot World of Julian Robertson, Institutional Investor, May 1986, at 86.

See Douglas W. Hawes, Hedge Funds—Investment Clubs for the Rich, 23 Business Lawyer 576 (1968).

Transcripts of the Roundtable participants' presentations (“Roundtable Transcript”) and comments submitted in connection with the Roundtable are available at http://www.sec.gov/spotlight/hedgefunds.htm . Staff of the Commodity Futures Trading Commission (“CFTC”), the Commission des Operations de Bourse of France (COB), and the Financial Services Authority of the United Kingdom (FSA), participated in our Roundtable. In addition, Commission staff met with CFTC staff, staff of the Board of Governors of the Federal Reserve, staff of the Department of the Treasury, state securities officials, and staff of the FSA to discuss issues relating to hedge funds, their advisers, and their oversight.

Implications of the Growth of Hedge Funds, Staff Report to the United States Securities and Exchange Commission (“2003 Staff Hedge Fund Report”), available at http://www.sec.gov/ spotlight/hedgefunds.htm.

See, e.g., Hedge Funds Grab More In Fees As Their Popularity Increases, supra note 11; Alistair Bair, Pension Funds Seen Boosting Hedge-Fund Allocations, CBS MarketWatch, Sept. 13, 2004.

See Hennessee Group LLC, 10th Annual Manager Survey (2004).

Id. (Hennessee Group estimates that the 34 percent growth of hedge funds in 2003 was due to both performance (20 percent) and new capital (14 percent)). See also Sanford C. Bernstein & Co., Hedge Fund Industry Update “ One Year Later, The Song Remains The Same, Bernstein Research Call (July 28, 2004) (hedge fund assets grew globally by approximately 31 percent in calendar year 2003 with aggregate assets reaching $870 billion in March 2004) (“Bernstein 2004 Report”). Hedge fund inflows have also continued to set records. See Chris Clair, Hedge Fund Inflows Set Another Record, HedgeWorld/Inside Edge, Aug. 16, 2004 (second quarter 2004 inflows of $43.3 billion bested the record set in the first quarter); Too Much Money Chasing Too Few Real Stars, Financial Times, July 22, 2004 (first quarter 2004 inflows were $38.2 billion, following record 2003 inflows of $72 billion).

Some estimate that hedge fund assets are already at or near $1 trillion. See Boom Or Bust? Banks And Hedge Funds, The Economist (Oct. 9, 2004); Daniel Kadlec, Will Hedge Funds Take A Dive?, Time, Oct. 4, 2004; Amey Stone, Hedge Funds Are Everyone's Problem, BUSINESSWEEK, Aug. 6, 2004.

As of the end of August 2004, equity mutual funds' assets were $3.8 trillion. At $870 billion, hedge funds' assets were equal to 22.9 percent of this figure. See Investment Company Institute, Trends in Mutual Fund Investing: August 2004, News Release (available at http://www.ici.org,, visited on Oct. 13, 2004).

Sanford C. Bernstein & Co., The Hedge Fund Industry—Products, Services, or Capabilities, Bernstein Research Call (May 19, 2003), at 5 (“Bernstein 2003 Report”).

Marcia Vickers, The Most Powerful Trader on Wall Street You've Never Heard of, BusinessWeek, July 21, 2003, at 66.

See Henny Sender, Hedge Funds Skid on Convertible Bonds, Wall St. J., June 30, 2004, at C4 (hedge funds account for about 95% of all trading in convertible bonds).

We are not alone in our concerns regarding hedge fund frauds. In a recent study, over 50 percent of respondents identified hedge funds as “most likely to be at the centre of an investment controversy” in the next five years. Bank of New York, RESTORING BROKEN TRUST (July 2004).

This reflects five cases in addition to those we cited in Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2266 (July 20, 2004) [69 FR 45171 (July 28, 2004)] (“Proposing Release”). Some commenters have suggested that the cases we cited in the Proposing Release did not support the need for hedge fund adviser registration because some of the hedge funds had less than $30 million in assets and advisers with less than $30 million in assets under management are not required to register under the Act. First, while staff estimates that approximately half the advisers in these cases managed assets in excess of $30 million or were otherwise subject to registration, it was cases involving these larger advisers that comprise the bulk of the estimated losses, representing more than $1 billion of total $1.1 billion of estimated losses. Second, regardless of whether any particular adviser would be required to register with us, these cases demonstrate the increased prevalence of fraud associated with hedge funds. We note that whether a particular hedge fund adviser will be required to register with us will turn not solely on the amount of assets of a particular hedge fund it advises, but on the total amount of assets the adviser has under management, including those of other clients. See section 203A(a)(1)(A) of the Advisers Act [15 U.S. 80b-3a(a)(1)(A)].

In the past year, we have sanctioned persons charged with late trading of mutual fund shares on behalf of groups of hedge funds, and mutual fund advisers or principals for permitting hedge funds' market timing. In the Matter of Invesco Funds Group, Inc., AIM Advisors, Inc., and AIM Distributors, Inc., Investment Advisers Act Release No. 2311 (Oct. 8, 2004) (Commission found that mutual fund adviser entered into an undisclosed arrangement permitting hedge funds to market time the adviser's mutual funds in a manner inconsistent with the mutual funds' prospectuses); SEC v. PIMCO Advisors Fund Management, LLC, Investment Advisers Act Release No. 2292 (Sept. 13, 2004) (Commission found that mutual fund adviser entered into a market timing arrangement permitting over 100 mutual fund market timing transactions by hedge funds in exchange for hedge funds' investment in adviser's other investment vehicles; mutual fund adviser also provided hedge funds with material nonpublic portfolio information concerning four of the adviser's mutual funds); In the Matter of Banc One Investment Advisors Corporation and Mark A. Beeson, Investment Advisers Act Release No. 2254 (June 29, 2004) (Commission found that investment adviser permitted Canary hedge fund manager Edward Stern to time the adviser's mutual funds, contrary to the funds' prospectuses; helped arrange financing for the timing trades; failed to disclose the timing arrangements; and provided Stern with nonpublic portfolio information); In the Matter of Pilgrim Baxter & Associates, Ltd., Investment Advisers Act Release No. 2251 (June 21, 2004) (Commission found that mutual fund adviser permitted a hedge fund, in which one of its executives had a substantial financial interest, to engage in repeated and prolonged short-term trading of several mutual funds and that one of its executives provided material nonpublic portfolio information to a broker-dealer, which passed it on to its hedge fund customers); In the Matter of Strong Capital Management, Inc., et al., Investment Advisers Act Release No. 2239 (May 20, 2004) (Commission found that investment adviser disclosed material nonpublic information about mutual fund portfolio holdings to Canary hedge funds, and permitted Canary and the adviser's own chairman to engage in undisclosed market timing of mutual funds managed by adviser); SEC v. Security Trust Co., N.A., Litigation Release No. 18653 (Apr. 1, 2004) (consent to judgment by trust company charged with facilitating late trades and market timing by affiliated hedge funds over at least a three-year period); In the Matter of Stephen B. Markovitz, Administrative Proceedings Release No. 33-8298 (Oct. 2, 2003) (Commission found that Markovitz engaged in late trading on behalf of hedge funds). See also In the Matter of Alliance Capital Management, L.P., Investment Advisers Act Release No. 2205 (Dec. 18, 2003) (Commission found that investment adviser permitted known market timers, including Canary hedge funds, to market time its mutual funds, in exchange for the timers' investments in Alliance's investment vehicles); In the Matter of James Patrick Connelly, Jr., Investment Advisers Act Release No. 2183 (Oct. 16, 2003) (Commission found that vice chairman of mutual fund adviser permitted market timing by known market timer, including at least one hedge fund). We have also sanctioned mutual fund advisers for permitting certain investors to engage in undisclosed market timing of their funds; hedge funds were among the market timers in these cases. In the Matter of RS Investment Management, Investment Advisers Act Release No. 2310 (Oct. 6, 2004); In the Matter of Janus Capital Management, LLC, Investment Advisers Act Release No. 2277 (Aug. 18, 2004). In addition, we have sanctioned insurance companies for facilitating undisclosed market timing of mutual funds through variable annuity products marketed and sold to market timers including hedge funds. In the Matter of CIHC, Inc., Conseco Services, LLC, and Conseco Equity Sales, Inc., Investment Company Act Release No. 26526 (Aug. 9, 2004) and In the Matter of Inviva, Inc. and Jefferson National Life Insurance Company, Investment Company Act Release No. 26527 (Aug. 9, 2004).

We are continuing to pursue several similar cases. To date, we have instituted six enforcement actions (in addition to the 12 settled actions discussed above). See SEC v. Geek Securities, Inc., Litigation Release No. 18738 (June 4, 2004) (alleging that broker-dealer engaged in late trading of mutual funds on behalf of several hedge fund customers, and facilitated hedge funds' market timing transactions in numerous mutual funds by evading the mutual funds' attempts to restrict the transactions); SEC v. Columbia Management Advisors, Inc., Litigation Release No. 18590 (Feb. 24, 2004) (alleging mutual fund wholesaler entered into, and adviser approved, arrangements allowing hedge funds to engage in market timing transactions in nine mutual funds, including one aimed at young investors); SEC v. Mutuals.com, Inc., Litigation Release No. 18489 (Dec. 4, 2003) (alleging that dually registered broker-dealer and investment adviser, three of its executives, and two affiliated broker-dealers assisted hedge fund brokerage customers in carrying out and concealing thousands of market timing trades and illegal late trades in shares of hundreds of mutual funds); SEC v. Druffner, Litigation Release No. 18444 (Nov. 4, 2003) (alleging that five brokers, with the assistance of their branch office manager, evaded attempts to restrict their trading and assisted several hedge funds in conducting thousands of market timing trades in numerous mutual funds); In the Matter of Theodore Charles Sihpol, III, Securities Exchange Act Release No. 48493 (Sept. 16, 2003) (charging former broker with playing a key role in enabling Canary hedge fund to engage in late trading in mutual fund shares over a three-year period). See also In the Matter of Paul A. Flynn, Securities Exchange Act Release No. 49177 (Feb. 3, 2004) (alleging Flynn assisted numerous hedge funds in obtaining bank financing to fund late trading and deceptive market timing of mutual fund shares).

Our Proposing Release reported only 40 hedge funds involved in these cases. Our staff has continued its investigation of late trading and market timing of mutual fund shares and, at our request, conducted a more detailed review. Staff has identified 389 different hedge funds, but in light of the continuing nature of staff's investigations, this number may be incomplete. Advisers registered with the Commission advised some of the 389 hedge funds.

See Harriet Johnson Brackey, New Class of Hedge Funds Reaches Beyond the Wealthy, San Jose Mercury News, Mar. 23, 2003; Pam Black, Going Mainstream, Registered Rep., Mar. 1, 2004; Hanna Shaw Grove and Russ Alan Prince, Let Us In, Registered Rep., Mar. 2004; Jane Bryant Quinn and Temma Ehrenfeld, The Street's Latest Lure: Some One Is Going to Mint Money With the New Hedge Funds For Smaller Investors, Newsweek, May 26, 2003. See also two recent articles discussing hedge funds in publications for physicians. John J. Grande, Alternative Investment Strategies Can Offer Significant ROI, Ophthalmology Times, May 15, 2002; Leslie Kane, Where to Put Your Money: Four Experts Tell Whether You Should Expect Happy Days for Stocks, and How to Invest Your Money, Medical Economics, Jan. 9, 2004. See also Jenna Gottlieb, Hedge Fund Deal Raises Product's Bank Profile, American Banker, Oct. 14, 2004 (one fund of hedge funds adviser stated that hedge funds are becoming mainstream and are marketed to the mass affluent).

See 2003 Staff Hedge Fund Report, supra note 18, at 81.

Any sales in the United States would, of course, be subject to the registration requirements of the Securities Act, and the hedge fund itself may be subject to the Investment Company Act, unless exemptions were available. See, e.g., Robert Murray, Vega To Target Smaller Investors, Alternative Investment News, Aug 20, 2004 (Spanish hedge fund adviser plans to offer a fund of its hedge funds to U.S. investors). The UK recently introduced a new type of vehicle which will be available only to sophisticated investors, but will still be authorized by the FSA, as a “half way house” between retail funds (fully regulated) and wholly unregulated funds. See Financial Services Authority, The CIS Sourcebook—A New Approach, Feedback on CP185 and Made Text, Mar. 2004, available at http://www.fsa.gov.uk/pubs/policy/04_07.pdf (visited on Oct. 25, 2004). The media recently reported that the FSA was examining whether it should lift the ban on letting ordinary members of the public invest in hedge funds. See FSA May Lift Ban on Hedge Fund Retail Investors, Reuters, Sept. 29, 2004, available at http://www.reuters.co.uk (visited on Sept. 29, 2004). Starting Jan. 2004, funds of hedge funds may sell their shares to smaller investors in Germany subject to certain regulations and procedures. See Silvia Ascarelli and David Reilly, Hedge Funds Are Coming to the Masses, Wall St. J., Apr. 15, 2004; EU Financial Services Group Briefing, Wilmer, Cutler & Pickering, Hedge Funds in Germany—German Parliament Opens the Market for Alternative Investment Products, Dec. 5, 2003, available at http://www.wilmer.com /pubs/results.aspx? iPractice (visited on Oct. 25, 2004). Since April 2003, funds of hedge funds may sell their shares to smaller investors in France, subject to certain regulations and procedures. See Commission des Operations de Bourse (France), Regulating Alternative Multi-Management Investments, News Release (Apr. 1, 2003) (available in File No. S7-30-04); Alain Gauvin and Guillaume Eliet, Capital Markets Dept., Coudert Freres, Regulating Alternative Multi-Management Investments, 2003, available at http://www.coudert.com (visited on Oct. 25, 2004). In Ireland, funds of hedge funds may sell their shares to smaller investors subject to certain regulations and procedures. See Matheson Ormsby Prentice, Establishing a Hedge Fund in Ireland, 2003, available at http://www.mop.ie/fileupload/ publications (visited on Oct. 25, 2004). In Asia, both Hong Kong and Singapore permit authorized hedge funds to sell their shares to investors subject to certain minimum subscription thresholds and regulations. See Donald E. Lacey, Jr., Democratizing the Hedge Fund: Considering the Advent of Retail Hedge Funds, Apr. 2003, (International Finance Seminar at Harvard Law School), available at http://www.law.harvard.edu/programs/pifs/pdfs/donald_lacey.pdf (visited on Oct. 25, 2004); Mattew Harrison, Fund Management in Hong Kong and Singapore, CSU Research and Policy, Jan. 6, 2003. In South Africa, regulators and trade associations recently issued a joint discussion paper to develop an acceptable regulated environment in which existing and new hedge funds can operate (including consideration of whether to permit certain hedge fund products to be marketed to the public). See The Financial Services Board, Association of Collective Investments and Alternative Investment Management Association, The Regulatory Position of Hedge Funds in South Africa—A Joint Discussion Paper (Mar. 9, 2004). See also Carla Fiford, South African Hedge Fund Industry Grows by Stealth, AIMA Journal, Feb. 2004. The media recently reported that in Luxembourg, changes to regulation have allowed offshore hedge funds to list in Luxembourg since September 2004. See Phil Davis, Special Report Luxembourg: Hedge Fund Tide May Be About to Turn, Financial Times, Oct. 18, 2004.

The Street's Latest Lure: Some One Is Going to Mint Money With the New Hedge Funds For Smaller Investors, supra note 31; Going Mainstream, supra note 31; Jessica Toonkel, Firms Take Pause Before Launching Hedge Funds of Funds for Mass Affluent; Hold Your Horses! Fund Action, Apr. 21, 2003; Michael P. Malloy and Jim Strangroom, Registered Funds of Hedge Funds, MFA Reporter (2002); Fool's Gold, The Economist, Sept. 1, 2001; Kimberly Hill, Investors Need Help With Hedge Funds, Fundfire, May 14, 2004.

An additional 51 funds of hedge funds are registered with the Commission as investment companies but can be sold only through private offerings. The Commission does not have data on the number of additional funds of hedge funds that exist but are not registered with the Commission.

Bernstein 2003 Report, supra note 24, at 18.

Hennessee Group LLC, 10th Annual Manager Survey, supra note 20 (“funds of funds continue to be the fastest growing source of capital for hedge funds, increasing 50 percent since January 1997 (from 16 percent to 24 percent)”). See also Pauline Skypala, Hedge Funds of Funds Booming, FT.com, Sept. 26, 2004 (Morgan Stanley research estimates that over two-thirds of hedge fund inflows are coming through funds of funds).

According to Greenwich Associates, about 20 percent of corporate and public plans in the United States were investing in hedge funds in 2002, up from 15 percent in 2001. Bernstein Research reports that, among the top 200 U.S. defined benefit plans, at least 15 percent have allocated a portion of their assets to hedge funds. Bernstein 2003 Report, supra note 24 at 13. Hennessee Group data indicate that pensions' investments in hedge funds increased from $13 billion in 1997 to $72 billion in 2004. See Testimony of Charles J. Gradante, Managing Principal, The Hennessee Group LLC, Before the Senate Committee on Banking, Housing and Urban Affairs, available at http://banking/senate.gov/_files/gradante.pdf (visited on Oct. 13, 2004); Hennessee Group LLC, 10th Annual Manager Survey, supra note 20. See also Hedge Funds Gaining Acceptance Among Pension Funds, Morningstar Web Site, June 27, 2003; Chris Clair, ‘Unprecedented Pressure’: Public Plans Race to Embrace Hedge Funds; This Time They Are Leading, Not Following, Their Corporate Counterparts, Pensions and Investments, July 8, 2002, at 2; Alaska Pension Allocates to Hedge Fund, Alternative Investment News, July 1, 2004 (the Alaska State Pension Investment Board has chosen three firms to manage its first $300 million hedge fund allocation).

Median strategic allocation to hedge funds by endowments and foundations was 11 percent in 2001, 10 percent in 2003 and forecast at 12.3 percent in 2005. See Goldman Sachs International and Russell Investment Group, Report on Alternative Investing by Tax-Exempt Organizations 2003, available at http://www.russell.com/II/Research_and Resources/Informative_Articles /Goldman_ Russell_ Survey.asp (visited on Sept. 18, 2004). Others estimate the average allocation to be 12 percent, see Bank of New York and Casey, Quirk & Acito, Institutional Demand for Hedge Funds: New Opportunities and New Standards, (Sept. 2004) (“BONY Report”) or as high as 17 percent of assets. See Hennessee Group, 2004 Hennessee Hedge Fund Survey of Foundations and Endowments (reporting that an average commitment of 17 percent of assets, and a projected commitment of 19 percent by 2005) (“Hennessee Foundation and Endowment Survey”). See also Lewis Knox, The Hedge Fund: Institutional Money is Swelling the Coffers of the World's Largest Hedge Fund Managers, 28 Institutional Investor (International Edition) 53 (June 1, 2003); Dan Neel, Michigan Preps For Hedge, Real Estate, Investment Management Weekly, Apr. 28, 2003; Virginia Exposure Soars to 60%, Financial News (Daily), Apr. 27, 2003 (University of Virginia has invested 50 percent of its portfolio in hedge funds, and plans to increase its exposure to 60 percent of its total portfolio); Chris Clair, Allocation Goal: 25%—UTIMCO Joins Billion-Dollar Hedge Fund Club, Pensions and Investments, Apr. 14, 2003, at 3; Chidem Kurdas, Hedge Funds Continue to Gain in Endowments' Alternative Investments, HedgeWorld Daily News, Apr. 7, 2003; Behind the Money Section; University of Wisconsin Searching for Hedge Funds, 4 Alternative Investment News, Feb. 1, 2003, at 20 ($300 million University of Wisconsin endowment will allocate up to 10 percent, or $25-30 million, to a fund of funds manager); Baylor University; Inside The Buyside; Increases Hedge Fund Activity by $20-25 Million, 4 Alternative Investment News, Feb. 1, 2003 at 6; Susan L. Barreto, Hedge Funds Become Saving Grace for Endowments in Tough Times, HedgeWorld Daily News, Apr. 4, 2002.

Since we issued our Proposing Release, industry observers have seen smaller foundations expressing growing interest in hedge funds. Family Foundations Move Towards Hedge Funds, Fundfire, Oct. 11, 2004 (family foundation consultant notes many family foundations, run by family members with limited investment knowledge, pursuing hedge fund investments). Also, in our Proposing Release, we identified a large number of pension plans that were investing or looking to invest in hedge funds. Since then, a number of additional pension plans have sought, or are seeking, hedge fund investment, according to one trade newsletter. Cincy Fund Will Weight Alts, Alternative Investment News, Oct. 8, 2004 (Cincinnati Retirement System will consider alternative investments in 2005); U.S. Pensions Examine Hedge Funds, Alternative Investment News, Oct. 8, 2004 (pension plans sponsored by the General Conference of Seventh Day Adventists, Tulare County (CA) Employees' Retirement Association, and City of Laredo (TX) Firefighters Retirement System are considering investment in hedge funds); Colorado Guns & Hoses Makes Overlay Play, Alternative Investment News, Oct. 1, 2004 (Colorado fire and police pension fund allocated $75 million to two hedge fund of funds managers); Service Employees Likely To Seek Hedge Fund of Funds, Alternative Investment News, Sept. 10, 2004 (Service Employees International Union pension fund may seek to invest up to 5 percent of its $1.5 billion in assets to hedge funds of funds); New Hampshire Eyes Hedge Funds, Alternative Investment News, Sept. 10, 2004 (New Hampshire Retirement System is considering allocating up to $100 million to one or more hedge fund of funds managers); San Bernardino Pension Picks AIG, Benchmark Plus, Alternative Investment News, Aug. 13, 2004 (San Bernardino County (CA) Employees Retirement Association allocated $100 million to each of two hedge fund of fund managers); L.A. Water Dept. To Consider Hedge Funds, Alternative Investment News, July 30, 2004 (defined benefit plan to consider its first allocation to hedge funds early in 2005).

BONY Report, supra note 39, at 1. See also Lewis Knox, The Hedge Fund: Institutional Money is Swelling the Coffers of the World's Largest Hedge Fund Managers, supra note 39.

Proposing Release, supra note 28.

In 1999, the President's Working Group on Financial Markets, in the wake of the near-collapse of Long Term Capital Management, Inc., (“LTCM”), published a series of recommendations that did not include registration of hedge fund advisers under the Advisers Act. See Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management—Report of the President's Working Group on Financial Markets, by representatives from the Commission, the Treasury Department, the Board of Governors of the Federal Reserve System and the Commodity Futures Trading Commission (Apr. 1999). The principal concerns of the President's Working Group report were the stability of financial markets and the exposure of banks and other financial institutions to the counterparty risks of dealing with highly leveraged entities such as the LTCM hedge fund. The focus of the Advisers Act is different, and includes such concerns as the prevention of frauds on investors. Since the issuance of the President's Working Group report, the size of the hedge fund industry has doubled, the exposure of investors to hedge funds has broadened, and the incidence of fraud we discover involving hedge fund advisers has increased. The Commission is the only member of the President's Working Group with responsibility for the protection of investors and the oversight of our nation's securities markets.

These letters are available on the Internet at http://www.sec.gov/rules/proposed/s73004.shtml.

See, e.g., Comment Letter of Van Hedge Fund Advisors (Sept. 15, 2004) (“Van Hedge Letter”).

Hennessee Group also submitted the results of a survey of foundations and endowments, Hennessee Foundation and Endowment Survey, supra note 39. Nearly twice as many respondents to the Hennessee Foundation and Endowment Survey favored the proposal (59 percent) as opposed it (30 percent).

See, e.g., Comment Letter of Ohio Public Employees Retirement System, (Aug. 6, 2004) (“Ohio PERS Letter”); Comment Letter of New Jersey State Investment Council (Sept. 17, 2004) (“New Jersey State Investment Council Letter”); Comment Letter of Pennsylvania Securities Commission (July 26, 2004) (“Pennsylvania Securities Commission Letter”); Comment Letter of CFA Institute (Sept. 30, 2004) (“CFA Institute Letter”); Comment Letter of Investment Counsel Association of America (Sept. 14, 2004) (“ICAA Letter”); Comment Letter of Alternative Investment Group Services, LP (Aug. 20, 2004) (“Alternative Investment Group Letter”); Comment Letter of Lyn Batty (July 14, 2004) (“Lyn Batty Letter”).

See, e.g., Comment Letter of Investment Company Institute (Sept. 15, 2004) (“ICI Letter”); Ohio PERS Letter, supra note 47; Comment Letter of Investment Management Consultants Association (Sept. 14, 2004) (“IMCA Letter”); Alternative Investment Group Letter, supra note 47; Comment Letter of David Patch (July 24, 2004) (“Patch Letter A”).

See, e.g., Comment Letter of B. H. Bigg (July 23, 2004) (“Bigg Letter”); Comment Letter of Ralph S. Saul (Aug. 18, 2004) (“Saul Letter”).

See, e.g., Comment Letter of Vantis Capital Management LLC (Aug. 6, 2004) (“Vantis August Letter”); Alternative Investment Group Letter, supra note 47.

See, e.g., Comment Letter of Managed Funds Association (Sept. 15, 2004) (“MFA Letter”); Comment Letter of Madison Capital Management, LLC (Sept. 15, 2004)(“Madison Capital Letter”); Comment Letter of Proskauer Rose LLP (Aug. 31, 2004) (“Proskauer Letter”); Comment Letter of Schulte Roth & Zabel LLP (Sept. 15, 2004) (“Schulte Roth Letter”); Comment Letter of Keith Black (July 30, 2004) (“Black Letter”); Comment Letter of Guy Lander (Sept. 15, 2004) (“Lander Letter”); Comment Letter of Sidley Austin Brown & Wood, LLP (Sept. 14, 2004) (“Sidley Austin Letter”); Comment Letter of Joseph LaRocco (Aug. 26, 2004) (“LaRocco Letter); Comment Letter of Superior Capital Management LLC (Sept. 8, 2004) (“Superior Capital Letter”).

See, e.g., MFA Letter, supra note 51; Comment Letter of Chamber of Commerce of the United States of America (Sept. 15, 2004) (“Chamber of Commerce Letter”); Comment Letter of International Swaps and Derivatives Association (Sept. 15, 2004) (“ISDA Letter”); Comment Letter of David Patch (Sept. 10, 2004) (“Patch Letter B”); Comment Letter of Rodney Pitts (Sept. 15, 2004) (“Rodney Pitts Letter”); Comment Letter of Blanco Partners LP (Sept. 13, 2004) (“Blanco Partners Letter”); Comment Letter of Mark Acquino (Aug. 8, 2004)(“Acquino Letter”).

See, e.g., MFA Letter, supra note 51; Chamber of Commerce Letter, supra note 52; ISDA Letter, supra note 52; Comment Letter of Financial Services Roundtable (Sept. 9, 2004) (“Financial Services Roundtable Letter”); Black Letter, supra note 51; Comment Letter of Tudor Investment Corporation (Sept. 15, 2004) (“Tudor Letter”); Comment Letter of David Thayer (Sept. 15, 2004) (“David Thayer Letter”); Lander Letter, supra note 51.

See, e.g., Comment Letter of John Waller (July 31, 2004) (“John Waller Letter”); Acquino Letter, supra note 52; Comment Letter of Melissa Kadiri (Sept. 15, 2004) (“Melissa Kadiri Letter”).

During and after the comment period, our staff has continued to have discussions in the President's Working Group with other regulators relating to hedge fund adviser regulation. See Letter from Congressman Richard H. Baker to John W. Snow, Secretary, U.S. Department of the Treasury (Oct. 7, 2004) (available in File S7-30-04).

As discussed below, we are also adopting amendments to rules 203A-3, 204-2, 205-3, 206(4)-2, and 222-2. Unless otherwise noted, when we refer to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 206(4)-2, 222-2, or any paragraph of the rules, we are referring to 17 CFR 275.203(b)(3)-1, 275.203A-3, 275.204-2, 275.205-3, 275.206(4)-2, and 275.222-2 of the Code of Federal Regulations in which the rules are published.

See Capital Gains, supra note 1.

See, e.g., AUSA Life Insurance Co. v. Ernst & Young, 206 F.3d 202 (2nd Cir. 2000) at 217. “During the Great Depression, Congress enacted the 1933 and 1934 [Securities] Acts to promote investor confidence in the United States securities markets and thereby to encourage the investment necessary for capital formation, economic growth, and job creation.” Private Securities Litigation Reform Act of 1995, Pub. L. 104-67, S.Rep. No. 104-98 (June 19, 1995), reprinted in 1995 U.S.C.C.A.N. 679, 683.

See American Trucking Assns., Inc. v. Atchison, Topeka & Santa Fe Ry Co., 387 U.S. 397, 415 (1967) (“Regulatory agencies do not establish rules of conduct to last forever; they are supposed, within the limits of the law and of fair and prudent administration, to adapt their rules and practices to the Nation's needs in a volatile, changing economy. They are neither required nor supposed to regulate the present and the future within the inflexible limits of yesterday.”).

William Fung and David Hsieh, Measuring the Market Impact of Hedge Funds, 7 J. of Empirical Fin. 1 (2000) (“There are varying estimates of the size of the hedge fund industry.”); Hedg-matics: How Many Funds Exist? Wall St. J., May 22, 2003, at C5 (“Just how big is the hedge-fund industry? This simple question has been debated because the data on hedge funds are spotty.”); Letter from Craig S. Tyle, General Counsel of the Investment Company Institute, to Jonathan G. Katz, Secretary, U.S. Securities and Exchange Commission, July 2, 2003, available at http://www.ici.org (visited on Oct. 10, 2004) (“There is currently no universal database that contains records of all hedge funds, both those currently operating and those that have ceased operating.”); Gaurav S. Amin and Harry M. Kat, Hedge Fund Performance 1990-2000: Do the “Money Machines” Really Add Value?, 38 Journal of Financial and Quantitative Analysis 2 (2003) (“Due to its private nature, it is difficult to estimate the current size of the hedge fund industry.”). See also Bing Liang, Hedge Funds: The Living and the Dead, 35 Journal of Financial and Quantitative Analysis 309-326 (2000) (study of statistical inconsistencies in two major hedge fund databases, noting hedge funds “are basically not regulated. They report their fund information only on a voluntary basis. Therefore, the reliability of hedge fund data is an open question and is critical for hedge fund research and the investment community.”); Harry M. Kat, 10 Things That Investors Should Know About Hedge Funds, Institutional Investor (Spring 2003) (noting that hedge fund databases are of low quality, that each database covers only a subset of the hedge fund universe, that all present survivorship bias, and that researchers attempting to analyze the hedge fund industry or fund performance may perceive matters very differently depending on the database or index they use).

CFA Institute agreed that the fact that many registered advisers are small firms “argues strongly that such registration is not overly burdensome.” CFA Institute Letter, supra note 47.

We estimated, in the Proposing Release, that 40-50 percent of hedge fund advisers are registered under the Act. See Section V. of the Proposing Release. See also Hennessee Group LLC, 10th Annual Manager Survey, supra note 20 (39 percent of hedge fund managers surveyed were registered under the Advisers Act).

Moreover, many hedge fund advisers that are not registered with us have indicated that they conform their operations to those of registered advisers. See 2003 Staff Hedge Fund Report, supra note 18, at 314.

See Vantis August Letter, supra note 50 (“While there are incremental costs associated with registration [under the Advisers Act], the burdens are not excessive for any serious investment firm, which is committed to timely and accurate reporting.”) and Alternative Investment Group Letter, supra note 47 (“We believe that the compliance costs will be minimal to the well-managed advisor.”).

The antifraud prohibitions of section 206 [15 U.S.C. 80b-6], including provisions restricting an adviser's ability to engage in principal trades and agency cross-transactions with clients, apply to any investment adviser that makes use of the mails or any means of interstate commerce. In contrast, section 204 [15 U.S.C. 80b-4] (authorizing the Commission to require advisers to issue reports and maintain books and records) applies to all advisers other than those specifically exempted from registration by section 203(b) of the Act. Thus, although unregistered advisers are subject to the antifraud provisions of the Act, our ability to enforce those provisions is hampered because in the absence of a registration requirement we cannot identify and examine these advisers.

In the past, hedge fund industry participants cited the restrictions on registered advisers charging performance-based compensation in section 205(a)(1) of the Act [15 U.S.C. 80b-5(a)(1)] as being incompatible with the operation of hedge funds. See Hard Times Come to the Hedge Funds, supra note 13; Lawrence J. Berkowitz, Regulation of Hedge Funds, 2 Rev. of Securities Reg. (1969). In 1998, however, the Commission eliminated this concern by adopting amendments to rule 205-3. Exemption to Allow Investment Advisers to Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's Account, Investment Advisers Act Release No. 1731 (July 15, 1998) [63 FR 39022 (July 21, 1998)]. Further, we proposed to grandfather hedge fund advisers' existing investors that would otherwise not qualify to pay performance fees. See Section II.G. of the Proposing Release. No hedge fund industry participant with whom our staff spoke during their year-long investigation indicated that section 205 or the qualified client criteria in rule 205-3 would present any concerns to hedge funds.

See, e.g., ICI Letter, supra note 48 (“Many of our investment adviser members—all of whom are registered with the Commission—currently operate hedge funds and have found that registration is not overly burdensome and does not interfere with their investment activities.”).

Id. Nor does the Act restrict the ability of advisers to engage in short-selling. Moreover, nothing in the Act or our rules requires any investment adviser to disclose its securities positions. Indeed, we recently declined requests to require advisers to publicly disclose how they voted client proxies out of a concern that they would thereby divulge client securities positions. Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003) [68 FR 6585 (Feb. 7, 2003)]. The Advisers Act requires us to maintain as confidential information obtained by our examiners in the course of an examination. See sections 210(b) and 210A of the Act [15 U.S.C. 80b-10(b) and 10a].

Bids and Offers, Wall St. J., July 23, 2004 at C4. In the study, Hedge Fund Research, Inc., an alternative investments research and consulting firm, examined the performance of approximately 2,200 single-strategy hedge funds. Id. However, the extent of cross-sectional variability in hedge fund returns makes it difficult to ascertain differences in performance statistically.

See The Hedge Fund 100, Institutional Investor, May 2004.

In its investigation of hedge funds, see supra Section I of this Release, our staff conducted reviews of registered and unregistered hedge fund advisers, had on-site discussions with them, and met or spoke with a variety of experts to get their perspectives on the hedge fund industry. 2003 Staff Hedge Fund Report, supra note 18, at 2.

See, e.g., Chamber of Commerce Letter, supra note 52.

Many of the fears concerning Commission oversight expressed by hedge fund advisers today are very similar to those expressed in 1940 by opponents to enactment of the Advisers Act. See, e.g., Investment Trusts and Investment Companies: Hearings on S.3580 Before the Senate Comm. on Banking and Currency, 76th Cong., 3d. Sess. (Apr. 22-23, 1940) (“1940 Senate Hearings”) (testimony of James N. White, Scudder, Stevens & Clark, (“We just feel that registration leads to investigation, and that investigation leads to regulation; and it is possible for a good deal of controversial theory on economics to creep into regulation.”)), (testimony of Dwight C. Rose, President, Investment Counsel Association of America, (“* * *all activities and recommendations of a cautious investment counselor would first have to be subjected to the question of whether or not at some time such activities or recommendations might involve difficulties for him in connection with the statute as enacted or with such future rulings as the Commission might take.”)), (testimony of Charles M. O'Hearn, Clarke, Sinsabaugh & Co., (“In addition, we should like to reaffirm our belief that we should be forced to take this position [against adviser registration] in the interests of our profession, even if we believed some Federal regulation was desirable, because of the broad and unqualified discretion given to the Securities and Exchange Commission to determine conditions which are vital not only to the convenience but to the very existence of our operations.”)). Registration, however, clearly has not impeded the growth of the investment advisory industry—in 1940, investment advisers managed only $4 billion (approximately $50 billion in today's dollars), but assets managed by advisers subject to registration under the Advisers Act have grown to over $23 trillion today.

See Sections II.F. through II.H. of the Proposing Release.

See Section II.I. of this Release.

One of these considerations—imposition of minimal burdens—is discussed above.

Collecting information about the nation's investment advisers has been one aim of the Advisers Act since it was enacted in 1940. Although the primary objective of the Advisers Act is the protection of advisory clients, the Act also serves as “a continuing census of the Nation's investment advisers.” H.R. Rep. No. 1760, at 2 (1960). Just as data on all advisers was lacking before 1940, there has been no comprehensive data on hedge fund advisers available. See supra note 60.

Much of this information is currently collected from hedge fund advisers that are registered with the Commission. A registered adviser that is the general partner of a hedge fund must report that it advises a “pooled vehicle” in response to Item 5.D (6) of Part 1A of Form ADV, list each pooled vehicle on Schedule D (Section 7.B.) and disclose the amount of assets in the pooled vehicle and the minimum amount of capital investment per investor.

See Bernstein 2004 Report, supra note 21, at 2 (“In general, there are very wide discrepancies in market size and performance estimates from different sources. As an example, we found that among three leading hedge fund data providers only approximately 15 percent of funds were included in all three databases.”); see also supra note 60.

Even commenters that disagreed with our proposal to register hedge fund advisers agreed that the Commission needs information about them. See, e.g., Comment Letter of Kynikos Associates LP (Sept. 15, 2004) (“Kynikos Letter”).

See, e.g., Chamber of Commerce Letter, supra note 52; MFA Letter, supra note 51.

One commenter agreed with our concerns and the inadequacy of alternative approaches to collecting information about hedge fund managers. See Comment Letter of Long Trail Capital, LLC (Sept. 14, 2004) (Monitoring prime broker information is no substitute for registration of hedge fund advisers because (1) funds use multiple prime brokers, complicating efforts to monitor a fund; (2) the transactional picture is not complete since funds may hold private equity, real estate, or derivatives not cleared by the prime broker; (3) brokers have an incentive to profit from the client relationship with the fund, and not to expend resources trying to oversee its activities; fund advisers should instead be accountable to an overseer with a primary mission to protect investors.)

See supra note 7.

One registered hedge fund adviser commented that it benefits from our examination process. See Vantis August Letter, supra note 50 (“[T]he examiner provides an extra set of critical eyes to review our systems and identify any deficiencies. If we were to have deficiencies, we would want to promptly correct them.”)

During an examination, our staff may review the advisory firm's internal controls and procedures; they may examine the adequacy of procedures for valuing client assets, for placing and allocating trades, and for arranging for custody of client funds and securities. Examination staff also may review the adviser's performance claims and delivery of its client disclosure brochure. Each of these operational areas presents a greater opportunity for misconduct if it is not open to examination.

Other protections of the Advisers Act would also act as deterrents to unlawful conduct by serving as a check on the advisers' control of assets in funds they advise and contribute to the protection of investors in those funds. Our custody rule, for example, requires the adviser to maintain fund assets with a qualified custodian. See rule 206(4)-2 under the Advisers Act.

The facts of the action against Stevin R. Hoover and Hoover Capital Management, Inc. are instructive on this question. See SEC v. Hoover and Hoover Capital Management, Inc., (Second Amended Complaint of the SEC), (available at http://www.sec.gov/litigation/complaints /complr17487.htm). Hoover was involved in a scheme to defraud clients of his advisory firm by, among other things, misappropriating assets and overbilling expenses. When Hoover became aware that the Commission staff was investigating his firm, he established a separate, unregistered advisory firm and perpetuated his fraud through use of a hedge fund he created and controlled.

Several studies examine the impact of deterrence on the decision to commit crimes in different contexts. The seminal paper in this area is Gary Becker, Crime and Punishment: An Economic Approach, 76 J. Political Econ. 169 (1968). Another influential paper is Isaac Ehrlich, Participation in Illegitimate Activities: A Theoretical and Empirical Investigation, 81 J. Political Econ. 521 (1973). The deterrence hypothesis is also discussed in Robert Cooter and Thomas Ulen, Law and Economics, ch.11-12 (1988).

See, e.g., MFA Letter, supra note 51; ISDA Letter, supra note 52; Chamber of Commerce Letter, supra note 52; Schulte Roth Letter, supra note 51, Black Letter, supra note 51, David Thayer Letter, supra note 53; Comment Letter of Sheila C. Bair (Sept. 15, 2004) (“Sheila Bair Letter”).

2003 Staff Hedge Fund Report, supra note 18, at 72.

Some of these hedge fund managers may have been part of a scheme to defraud mutual fund investors and aided and abetted others in defrauding them, in violation of federal securities laws.

See, e.g., Comment Letter of Millrace Asset Group (Sept. 15, 2004) (“Millrace Letter”).

See S. Rep. No. 1760, at 3 (1960) (recommending amendments to the Advisers Act that gave Commission examination authority, explaining that “[t]he prospect of an unannounced visit of a Government inspector is an effective stimulus for honesty and bookkeeping veracity.”).

Eight of the 51 cases involved registered hedge fund advisers, and routine or sweep exams were the source of five of those eight cases. In the Matter of Alliance Capital Management, L.P., supra note 29 (Commission found that investment adviser to hedge fund and mutual funds permitted market timing of the mutual funds in exchange for the timers' agreements to invest in the hedge fund); In the Matter of Nevis Capital Management, LLC, David R. Wilmerding, III and Jon C. Baker, Investment Advisers Act Release No. 2214 (Feb. 9, 2004) (charging hedge fund adviser with misallocating favorable investment opportunities); In the Matter of Zion Capital Management LLC, and Ricky A. Lang, Investment Advisers Act Release No. 2200 (Dec. 11, 2003) (charging hedge fund adviser with misallocating investment opportunities to the adviser's personal account); SEC v. Schwendiman Partners, LLC, Gary Schwendiman, and Todd G. Schwendiman, Investment Advisers Act Release No. 2043 (July 11, 2002) (charging hedge fund adviser with usurping favorable investment opportunities, for the benefit of the adviser); In the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, Investment Advisers Act Release No. 2038 (June 20, 2002) (Commission found hedge fund adviser caused its hedge funds to pay nearly $2 million in unnecessary and undisclosed commission costs, above markups already paid, to broker that had no role in executing trades, as reward for referring investors to the hedge funds).

SEC v. KS Advisors, Inc., et al., Litigation Release No. 18600 (Feb. 27, 2004) (asserting hedge fund advisers misrepresented performance and net asset value of two hedge funds to conceal massive trading losses); SEC v. James S. Saltzman, Litigation Release No. 17158 (Sept. 27, 2001) (asserting hedge fund adviser diverted significant amounts of fund assets to personal use).

See, e.g., Schulte Roth Letter, supra note 51; Sidley Austin Letter, supra note 51.

SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, Litigation Release No. 18216 (July 7, 2003); SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, Litigation Release No. 18214 (July 3, 2003); SEC v. David M. Mobley, Sr., et al., Litigation Release No. 18150 (May 20, 2003); SEC v. Vestron Financial Corp., et al., Litigation Release No. 18065 (Apr. 2, 2003); SEC v. Hoover and Hoover Capital Management, Inc., Litigation Release No. 17487 (Apr. 24, 2002); SEC v. Beacon Hill Asset Management LLC, et al., Litigation Release No. 18745A (June 16, 2004); SEC v. House Asset Management, L.L.C., House Edge, L.P., Paul J. House, and Brandon R. Moore, Litigation Release No. 17583 (June 24, 2002); SEC v. Edward Thomas Jung, et al., Litigation Release No. 17417 (Mar. 15, 2002); SEC v. Evelyn Litwok & Dalia Eilat, Litigation Release No. 16843 (Dec. 27, 2000); SEC v. Ashbury Capital Partners, L.P., Ashbury Capital Management, L.L.C., and Mark Yagalla, Litigation Release No. 16770 (Oct. 17, 2000).

SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer Management Group II, LLC, Litigation Release No. 18247 (July 23, 2003); SEC v. Burton G. Friedlander, Litigation Rel. No. 18426 (Oct. 24, 2003).

In the Matter of Samer M. El Bizri and Bizri Capital Partners, Inc., Admin Proc. File No. 3-11521 (June 16, 2004); SEC v. Millennium Capital Hedge Fund, Litigation Release No. 18362 (Sept. 25, 2003); SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra note 97; SEC v. David M. Mobley, Sr., et al., supra note 97; SEC v. Hoover and Hoover Capital Management, Inc., supra note 97; SEC v. Beacon Hill Asset Management LLC, et al., supra note 97; SEC v. Edward Thomas Jung, et al., supra note 97; SEC v. Michael W. Berger, Manhattan Capital Management Inc., Litigation Release No. 17230 (Nov. 3, 2001); In the Matter of Charles K. Seavey and Alexander Lushtak, Investment Advisers Act Release No. 1968 (Aug. 15, 2001); In the Matter of Michael T. Higgins, Investment Advisers Act Release No. 1947 (June 1, 2001); SEC v. Ashbury Capital Partners, L.P., Ashbury Capital Management, L.L.C., and Mark Yagalla, supra note 97.

SEC v. J. Scott Eskind, Litigation Release No. 18558 (Jan. 29, 2004); SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, supra note 97; SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra note 97; SEC v. Vestron Financial Corp., et al., supra note 97; SEC v. House Asset Management, L.L.C., House Edge, L.P., Paul J. House, and Brandon R. Moore, supra note 97; SEC v. Evelyn Litwok & Dalia Eilat, supra note 97; SEC v. Ashbury Capital Partners, L.P., Ashbury Capital Management, L.L.C., and Mark Yagalla, supra note 97.

SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra note 97; SEC v. David M. Mobley, Sr., et al., supra note 97; SEC v. Edward Thomas Jung, et al., supra note 97; SEC v. Ashbury Capital Partners, L.P., Ashbury Capital Management, L.L.C., and Mark Yagalla, supra note 97.

We have also charged registered hedge fund advisers with other types of fraud, including: misallocating favorable investment opportunities to a hedge fund, to the detriment of the adviser's other clients, In the Matter of Nevis Capital Management, LLC, David R. Wilmerding, III and Jon C. Baker, supra note 94; misallocating investment opportunities to the personal account of a hedge fund adviser, to the detriment of the hedge fund, In the Matter of Zion Capital Management LLC, and Ricky A. Lang, supra note 94; usurping a profitable, low-risk investment opportunity available to a hedge fund and taking it for the personal benefit of a hedge fund adviser, SEC v. Schwendiman Partners, LLC, Gary Schwendiman, and Todd G. Schwendiman, supra note 94; and causing hedge funds to pay commissions to a broker that had no role in executing trades, as reward for referring investors to the adviser's hedge funds, In the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, supra note 94. We have no reason to believe that unregistered advisers may not be perpetrating the same types of frauds, beyond our detection.

SEC v. Global Money Management, L.P., Litigation Release No. 18666 (Apr. 12, 2004); SEC v. Burton G. Friedlander, supra note 98; SEC v. Michael Lauer, Lancer Management Group, LLC, and Lancer Management Group II, LLC, supra note 98; SEC v. David M. Mobley, Sr., et al., supra note 97; SEC v. Beacon Hill Asset Management LLC, et al., supra note 97; SEC v. Edward Thomas Jung, et al., supra note 97; In the Matter of Charles K. Seavey and Alexander Lushtak, supra note 99; In the Matter of Michael T. Higgins, supra note 99.

Section 203(c)(2) of the Advisers Act [15 U.S.C. 80b-3(c)(2)] permits the Commission, after notice and opportunity for a hearing, to deny registration to an adviser that is subject to disqualification under section 203(e) [15 U.S.C. 80b-3(e)]. Item 11 of Part 1 of Form ADV requires applicants for registration as an investment adviser to report felonies and other disciplinary events occurring during the last 10 years. The Commission's screening, however, does not rely exclusively on an applicant's self-reporting of violations; our staff checks applicants against a large database of securities violators to determine whether there are any unreported disciplinary events.

See, e.g., SEC v. J. Scott Eskind, supra note (Eskind, already barred by the Commission from association with any investment adviser, raised more than $3 million from investors for a purported hedge fund, and simply misappropriated it); SEC v. Sanjay Saxena, Litigation Release No. 16206 (July 8, 1999) (Saxena, already barred by the Commission from the securities industry, defrauded hedge fund investors of approximately $700,000).

SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, supra note (defendants raised nearly half a million dollars, the majority of which were simply misappropriated by Jean Pierre); SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra note 97 (Chabot raised over $1.2 million for an alleged hedge fund but did not buy any stocks or other securities with the funds, instead using the money for his personal expenses).

Comment Letter of Vantis Capital Management LLC (July 14, 2004) (“Vantis July Letter”) (registered hedge fund adviser stated that the lack of scrutiny of hedge fund advisers has led to the industry attracting “unsavory characters”).

We acknowledge that many new sponsors of hedge funds may not have $25 million of assets under management and thus may not be required to register with us. See section 203A(a)(1) of the Act [15 U.S. 80b-3a(a)(1)] (prohibiting certain advisers having less than $25 million from registering with the Commission). It is likely that if we adopt this rule, many prospective investors may insist that newly-formed hedge fund advisers be registered with the Commission. These advisers will apply for registration pursuant to our rule 203A-2(d) [17 CFR 275.203A-2(d)], which permits an adviser with less than $25 million of assets under management to register with us if the adviser has a reasonable expectation that it will be eligible to register within 120 days.

Rule 206(4)-7 [17 CFR 275.206(4)-7].

See Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)].

See, e.g., MFA Letter, supra note 51; Madison Capital Letter, supra note 51; Sidley Austin Letter, supra note 51.

See Comment Letter of Seward & Kissel LLP (Sept. 15, 2004) (“Seward & Kissel Letter”); Comment Letter of Bryan Cave LLP (Aug. 16, 2004) (“Bryan Cave Letter”).

In the Proposing Release, we estimated that the new registrants would need to spend $20,000 in professional fees and $25,000 in internal costs, including staff time, to develop the compliance infrastructure required of a registered investment adviser. These estimates were based on our discussions with industry, including attorneys whose practice involved counseling registered and unregistered investment advisers. Commenters argued that their costs would be higher. We discuss the benefits and costs of our rulemaking in Section IV. of this Release.

See ICAA Letter, supra note 47. As of September 30, 2004, of the 8,535 advisers registered with the Commission, 2,758 reported on their Form ADV that they were managing less than $50 million in client assets.

See 2003 Staff Hedge Fund Report, supra note 18 at section VII.A.1.b.

BONY Report, supra note 39, at 15-16.

Rule 206(4)-7. Hedge fund advisers have substantial conflicts of interest, both with their hedge funds and with their investors. These conflicts arise from management strategies, fee structures, use of fund brokerage and other aspects of hedge fund management.

One hedge fund adviser agreed: “Benefits [of registration] include * * * the structure it provides for advisers” policies and procedures, the value of having an additional layer of oversight of advisers' compliance programs.” Vantis August Letter, supra note 50.

In concluding that registration would impose substantial burdens on a hedge fund adviser, several commenters mistakenly assumed that compliance with rule 206(4)-7(c) would require them to hire a new chief compliance officer. The rule requires all registered advisers to “designate” an individual as chief compliance officer, which could be an individual currently employed by the adviser who has similar responsibilities.

Some hedge fund advisers charge up to four percent in asset-based fees, and others take between 30 and 50 percent of their funds' profits. See Hedge Funds Grab More In Fees As Their Popularity Increases, supra note 11.

See Bernstein 2003 Report, supra note 24, at 4.

Id. at 15. See also Vantis July Letter, supra note 106 (“there are presently too few barriers to entry” in the hedge fund industry).

Bernstein 2003 Report, supra note 24, at 14. Regulatory oversight to deter frauds may forestall erosion of investor confidence in this growing industry. See, e.g., Vantis July Letter, supra note 106 (mandatory registration will improve the image of the hedge fund industry); Hennessee Foundation and Endowment Survey, supra note 39 (survey participant remark that registration “lends creditability to the field”); Comment Letter of North American Securities Administrators Association, Inc. (Oct. 18, 2004) (SEC registration will increase investor confidence, thereby benefiting hedge fund advisers).

See supra note 119.

Hedge funds in the United States are generally organized to avoid regulation under the Investment Company Act by qualifying for an exclusion, from the definition of “investment company,” under section 3(c)(1) [15 U.S.C. 80a-3(c)(1)] or 3(c)(7) [15 U.S.C. 80a-3(c)(7)] of that Act. There are no performance fee restrictions on 3(c)(7) funds, but each investor in the fund must be a “qualified purchaser,” which for natural persons generally means having investments of at least $5 million. See section 2(a)(51) of the Investment Company Act [15 U.S.C. 80a-2(a)(51)]. Rule 205-3 requires advisers to 3(c)(1) funds to consider each investor in the fund as a client for purposes of charging a performance fee.

See infra Section II.H of this Release.

Regulation D [17 CFR 230.501 through 508] exempts from registration under the Securities Act of 1933 offerings and sales of securities that satisfy certain conditions, including certain sales to “accredited investors.” As noted in the 2003 Staff Hedge Fund Report, supra note 18, at 313, our approach of leaving eligibility requirements for accredited investors unchanged also allows small businesses to continue to seek capital from historical sources.

Comment Letter of Denali Asset Management LLLP (Aug. 27, 2004) (“Denali Letter”); Comment Letter of Willkie Farr & Gallagher LLP (Sept. 13, 2004) (“Willkie Farr Letter”); Comment Letter of National Futures Association (Sept. 14, 2004) (“NFA Letter”); ICAA Letter, supra note 47; Comment Letter of Katten Muchin Zavis Rosenman (Sept. 14, 2004) (“Katten Muchin Letter”); Tudor Letter, supra note 53; Financial Services Roundtable Letter, supra note 53; Jeffrey R. Neufeld (Sept. 15, 2004) (“Neufeld Letter”); Kynikos Letter, supra note 80; Comment Letter of the Association of the Bar of the City of New York Committee on Futures Regulation (Sept. 15, 2004) (“NYC Bar Futures Committee Letter”); Comment Letter of the U.S. Commodity Futures Trading Commission (Oct. 22, 2004) (“CFTC Letter”).

15 U.S.C. 80b-203(b)(6). Congress enacted section 203(b)(6) as part of the Commodity Futures Modernization Act of 2000, Pub. L. 106-554, 114 Stat. 2763 (2000) (codified in scattered sections of the United States Code). A parallel provision was added simultaneously to the Commodity Exchange Act. Section 4m of the Commodity Exchange Act [7 U.S.C. 6m]. The exemption in section 203(b)(6) is not available if the firm acts as an adviser to a registered investment company or to a company that has elected to be a business development company under section 54 of the Investment Company Act [15 U.S.C. 80a-53].

Roundtable Transcript of May 15 at 236-37, supra note (statement of Jane Thorpe that “NFA certainly has the ability to go in and inspect vehicles that may not directly be trading in futures but based on a risk-based approach is going to focus on those areas that obviously it has the most and we have the most interest in”).

We note that the frequency with which hedge fund advisers may also be registered with the CFTC as commodity pool operators (“CPOs”) may diminish substantially in the future. The CFTC recently adopted rules that may permit most hedge fund advisers to now avoid registering as CPOs or commodity trading advisors (“CTAs”). See Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisors; Past Performance Issues (Aug. 1, 2003) [68 FR 47221 (Aug. 8, 2003)] (“CFTC 2003 Exemptive Release”) (adopting new rule 4.13(a)(3), which exempts CPOs from registration if the pool is sold only to accredited investors and engages in limited trading of commodity interests, new rule 4.13(a)(4), which exempts CPOs from registration if the pool is offered only to persons reasonably believed to be “qualified eligible persons,” and new rule 4.14(a)(10), which exempts CTAs who during the preceding 12 months provide advice to fewer than 15 legal entities). See also Susan Ervin, Downsizing Commodity Pool Regulation: The CFTC's New Initiative, Futures Industry, May/June 2003 (The CFTC has embarked upon a fundamental change in its regulatory program, which would free very sizable portions of the industry from CFTC regulation. Many new entrants would not need to register with the CFTC and many currently registered persons may elect to withdraw from registration.). We expect our staff will consult with the staff of the CFTC to discuss a variety of matters regarding examinations of hedge fund advisers, including the extent to which examinations should be coordinated or results shared.

We note, however, that without the new rule requiring registration, a hedge fund adviser can now choose to register under the Advisers Act but then withdraw its registration, for example, at the prospect of an examination. Thus, without the new rule, any moral hazard would already exist, but without necessarily providing hedge fund investors the benefit of our oversight of their advisers.

See, e.g., 1940 Senate Hearings, supra note (testimony of Dwight C. Rose, President, Investment Counsel Association of America, (“Many incompetents would be permitted to register and describe themselves as registered or licensed investment counsel. This badge of registration and apparent approval by the Federal Government might, therefore, in spite of any express provision denying such approval in the act itself, give to the unsophisticated investor a mistaken and completely underserved impression of qualification and standing.”)). Indeed, such an argument could be made against Commission regulation of any broker-dealer, transfer agent, or investment company.

Section 208(a) of the Act [15 U.S.C. 80b-8(a)]. A registered adviser may refer to itself as “registered” so long as the effect of registration is not misrepresented. Section 208(b) [15 U.S.C. 80b-8(b)].

Practically speaking, a single hedge fund can have up to 499 investors; beyond this limit, the fund faces potential obligations to register under section 12 of the Exchange Act [15 U.S.C. 78h] and rule 12g-1 [17 CFR 240.12g-1], generally requiring registration of any issue with 500 holders of record of a class of equity securities and assets in excess of $10 million. Since rule 203(b)(3)-1 has generally allowed an adviser to count each hedge fund as one client, a hedge fund adviser could have 14 funds with 499 investors in each, or a total of 6,986 investors.

See, e.g., Chamber of Commerce Letter, supra note 52; MFA Letter, supra note 51. Opponents of the Advisers Act made this same argument to Congress in 1940 without success. See, e.g., 1940 Senate Hearings, supra note (testimony of Charles O'Hearn, Clarke, Sinsabaugh & Co., (“Regulation of this profession by the Securities and Exchange Commission is not necessary for the protection of small, uninformed investors, since they do not use investment counsel service. There is a marked difference between the owners of investment trust securities and our clients. While investment trusts sell securities in amounts sufficiently small so that even the poorest may buy, our services are designed for and limited to a group of persons who are a minority in the community. We do not deal with the general public. Our clients represent substantial amounts of capital and have adequate means to inform themselves about us through their banking and legal affiliations.”)).

The Commission's 1939 Investment Trust Study to Congress, which preceded enactment of the Advisers Act, found that the average size of individual clients' accounts managed by advisers surveyed in 1936 was $281,000, which equals $3.8 million in today's value. Individual clients represented about 83 percent of these advisers' client base. See SEC, Investment Trusts and Investment Companies, H.R. Doc. No. 279, 76th Cong., 1st Sess., pt. 2 at 8-9 (1940).

See, e.g., section 3(c)(7) [15 U.S.C. 80a-3(c)(7)] of the Investment Company Act.

See section 201 of the Act [15 U.S. 80b-1] (activities of investment advisers are of national concern because they substantially affect national securities exchanges and the national economy).

The legislative history of section 3(c)(1) of the Investment Company Act of 1940 [15 U.S.C. 80a-3(c)(1)], a parallel section to section 203(b)(3) that was enacted at the same time, reflects Congress' view that privately placed investment companies, owned by a limited number of investors likely to be drawn from persons with personal, familial, or similar ties, do not rise to the level of federal interest. See 1940 Senate Hearings, supra note 73.

See section 201 of the Act.

See, e.g., sections 4(2) and 4(6) of the Securities Act of 1933 [15 U.S.C. 77d(2) and 77d(6)] and Regulation D and rule 144A [17 CFR 230.144A]; SEC v. Ralston Purina Co., 346 U.S. 119 (1953).

See, e.g., Comment Letter of Wilmer Cutler Pickering Hale and Dorr LLP (Sept. 8, 2004) (“Wilmer Cutler Letter”).

Pub L. No. 104-290, 110 Stat. 3416 (1996) (codified in scattered sections of the United States Code).

S.Rep. No. 104-293, at 10 (1996).

Title III of NSMIA amended the Advisers Act to allocate regulatory responsibility over advisers between the Commission and state securities authorities. It gave the Commission responsibility for advisers with more than $25 million of assets under management, and preempted state registration and other requirements for advisers registered with the Commission. These are firms that Congress concluded were “[l]arger advisers, with national businesses [that] should be registered with the Commission and be subject to national rules.” S. Rep. No. 293, 104th Cong., 2d Sess. (1996) at 3-4.

See, e.g., Financial Services Roundtable Letter, supra note 53; Tudor Letter, supra note 53. Another commenter suggested that the investments of the hedge fund adviser's insiders be excluded in applying the registration requirements. Comment Letter of Alex M. Paul (July 21, 2004). We are adopting a provision that allows an adviser to exclude certain knowledgeable insiders when counting its clients. See infra Section II.D.2 of this Release.

See, e.g., Chamber of Commerce Letter, supra note 52; Neufeld Letter, supra note 127 (increase accreditation standards, with exemptions for family members of advisory firms' employees). See also MFA Letter, supra note 51 (suggesting creation of investor accreditation standards under the Advisers Act for hedge fund investors).

Other commenters suggested variations with special rules for funds of funds or pension plans. Regardless of the extent to which these alternatives might limit indirect participation in hedge funds advised by unregistered advisers, these alternatives would not permit us to examine unregistered hedge fund advisers. See, e.g., Bryan Cave Letter, supra note 111 (apply investor accreditation standards to funds of funds on a look-through basis); Comment Letter of Leon M. Metzger (Sept. 15, 2004) (“Metzger Letter”) (require fund of funds whose investors do not meet accreditation standards to invest only in funds with registered advisers; coordinate with Department of Labor to prohibit pension fund investments in hedge funds with unregistered advisers); Madison Capital Letter, supra note 51 (apply the look-through for purposes of counting up to 15 clients, but the only investors that would be counted towards the limit would be (i) investors that did not meet 3(c)(7) “qualified purchaser” standards, (ii) pension funds, and (iii) registered investment companies).

See supra Section II.B.8 of this Release.

Form D [17 CFR 239.500] is the form filed with the Commission by issuers (including many hedge funds) that make private securities offerings in reliance on Regulation D. Other commenters suggested informational filing requirements but did not focus on Form D in particular. See, e.g., Comment Letter of the American Bar Association Section of Business Law (Sept. 28, 2004) (“ABA Letter”); MFA Letter, supra note 51 (informational filing coupled with certification that insiders of the adviser or its funds did not have disciplinary history that would be reportable under Form ADV, and adviser's agreement to provide certain additional information to the Commission on “special call” in limited circumstances).

These commenters suggested registration carve-outs apply to hedge fund advisers whose funds submitted the expanded Form D information and accepted investments only from persons meeting “accredited investor” or “qualified client” criteria. See, e.g., Bryan Cave Letter, supra note 111; Seward & Kissel Letter, supra note 111. Bryan Cave also suggested that hedge funds be covered under revised and expanded Suspicious Activity Reports (“SARs”), and any information reported be shared with the Commission to aid enforcement efforts. The Financial Crimes Enforcement Network requires banks, brokers, and other financial institutions to file SARs if the institution observes suspected or potential financial crimes. We believe this kind of monitoring of hedge funds' financial transactions with third parties would provide us only with partial information about hedge fund advisers' activities.

See, e.g., Comment Letter of Coudert Brothers LLP (Sept. 15, 2004) (“Coudert Letter”); Katten Muchin Letter, supra note 127.

See, e.g., Bryan Cave Letter, supra note 111; MFA Letter, supra note 51; Kynikos Letter, supra note 80. Kynikos suggested that each adviser certify its compliance with the custody, compliance, and code of ethics rules and its adherence to investor qualification standards, as well as provide investors with special disclosures of key valuation and allocation standards, and distribute quarterly unaudited and annual audited financial statements to investors. Other commenters similarly included audit requirements as part of their alternatives. See, e.g., Madison Capital Letter, supra note 51 (suggesting annual audit requirement (with results delivered to investors and the Commission) and expanded Form D information reporting); Willkie Farr Letter, supra note 127 (suggesting self-executing exemptive application procedure for advisers whose funds distribute audited financials and special valuation disclosures to investors). We have previously requested comment on alternatives that would incorporate private audits into our oversight of investment advisers. Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2017 (Feb. 5, 2003) [68 FR 7038 (Feb. 11, 2003)]. However, as commenters in that inquiry noted, reliance on auditors can be problematic, since their reviews are not necessarily designed to address all the issues addressed by our oversight program, and audit personnel do not necessarily have an in-depth knowledge of the Advisers Act. See, e.g., Comment Letter of the Council of Institutional Investors (April 10, 2003), available at http://www.sec.gov/rules/proposed/s70303/cii041003.htm.

Further, under this alternative, hedge fund advisers could not use Investment Adviser Registration Depository system (“IARD”), the electronic filing system that investment advisers use to make filings with us. Thus, information about investment advisers to hedge funds would not be integrated with information about other investment advisers, it would not be included in the data reports available to our staff, and disciplinary and other important information about hedge fund advisers would not be available to the public through the Investment Adviser Public Disclosure system, which draws data from the IARD.

See, e.g., MFA Letter, supra note 51; Tudor Letter, supra note 53.

See also supra notes 138-140 and accompanying text.

Before the Commission adopted the safe harbor in 1985, the staff issued numerous no-action letters that required an investment adviser to look through an entity and count each individual advisee or member as a separate client. See Ruth Levine, SEC Staff No-Action Letter (Dec. 15, 1976); David Shilling, SEC Staff No-Action Letter (Apr. 3, 1976); B.J. Smith, SEC Staff No-Action Letter (Dec. 25, 1975); S.S. Program Limited, SEC Staff No-Action Letter (Oct. 17, 1974); Wofsey, Rosen, Kweskin & Kuriansky, SEC Staff No-Action Letter (Apr. 25, 1974); Hawkeye Bancorporation, SEC Staff No-Action Letter (June 11, 1971). Ambiguity with respect to this issue was fueled in part by Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977), cert. denied, 436 U.S. 913 (1978), overruled on other grounds by TransAmerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979), in which the Second Circuit held that general partners of limited partnerships investing in securities were investment advisers. The Second Circuit originally characterized the individual limited partners as the “clients” of the general partner, (1976-77) Fed.Sec.L.Rep. (CCH) ¶ 95,889, at 91,282 n. 16, but later withdrew this characterization, 568 F. 2d at 872 n. 16, leaving unanswered the issue of whether the partnership, or each of the partners, should be “counted” as a client. For a discussion, see Robert Hacker and Ronald Rotunda, SEC Registration of Private Investment Partnerships after Abrahamson v. Fleschner, 78 Colum. L. Rev. 1471, 1477 (1978).

In other circumstances, we look through pools to the investors themselves in specifying advisers' obligations under the Advisers Act. See, e.g., rule 205-3(b) (requiring each investor in a private investment company to meet qualified client criteria if the adviser charges the private investment company a performance fee); rule 206(4)-2(a)(3)(iii) (requiring that custody account statements for funds and securities of limited partnerships for which the adviser acts as general partner be delivered to each limited partner). We note, also, that other regulators have required a look-through approach in similar circumstances. Various states look through investment vehicles to count the investors as “clients” of the adviser. See Comment Letter of North American Securities Administrators Association (Oct. 18, 2004) (“NASAA Letter”). In addition, section 4m(1) of the Commodity Exchange Act [7 U.S.C. 6m(1)] provides an exemption from CTA registration that parallels the exemption in section 203(b)(3) of the Advisers Act, and until recently, the CFTC looked through legal organizations to count owners for purposes of determining whether a person had provided commodity trading advice to more than 15 persons in the preceding 12 months. See Additional Registration and Other Regulatory Relief for Commodity Pool Operators and Commodity Trading Advisors, (Mar. 10, 2003) [68 FR 12622 (Mar. 17, 2003)] (proposing new rule 4.14(a)(10) to treat legal organizations as single clients).

See supra note 157.

See H.R. Rep. No. 96-1341, at 62-63 (1980) (“with respect to persons or firms which do not advise business development companies, [this amendment] is not intended to suggest that each shareholder, partner or beneficial owner of a company advised by such a person or firm should or should not be regarded as a client of that person or firm”), and S.Rep. No. 96-958 at 41.

Rule 203(b)(3)-1 Adopting Release, supra note 10 (by providing a safe harbor, rule 203(b)(3)-1 will provide greater certainty regarding when advisers can rely on section 203(b)(3)). Commenters did not challenge our authority to withdraw the safe harbor of rule 203(b)(3)-1(a)(2)(i) with respect to private funds.

Definition of “Client” for Purposes Relating to Limited Partnerships, Investment Advisers Act Release No. 956 (Feb. 25, 1985) [50 FR 8740 (Mar. 5, 1985)] (proposed rule [203(b)(3)-1] is intended to provide investment advisers to limited partnerships with greater certainty in determining the circumstances under which they may rely on section 203(b)(3)).

15 U.S.C. 80b-11(a). See also section 202(a)(17) of the Act [15 U.S.C. 80(b)-2(a)(17)] (“The Commission may by rules and regulations classify, for the purposes of any portion or portions of this title, persons, including employees controlled by an investment adviser.”).

15 U.S.C. 80b-6(4). The Supreme Court has upheld, in a similar context, our broad authority to prohibit acts not themselves fraudulent in order to prevent fraudulent or manipulative conduct. See U.S. v. O'Hagan, 521 U.S. 642, 672-73 (1997).

See section 204 of the Act [15 U.S.C. 80b-4] (inspection and examination authority).

See infra Section II.E of this Release.

See sections 3(a) and 3(b) of the Investment Company Act [15 U.S.C. 80a-3(a) and 80a-3(b)].

Although rule 203(b)(3)-1(c) provides that an adviser will not be deemed to be holding itself out generally to the public as an investment adviser solely as a result of participating in a non-public offering of limited partnership interests, there may be circumstances where the marketing activities of a hedge fund adviser go beyond the scope of this safe harbor.

See, e.g., Wilmer Cutler Letter, supra note 142. See also Comment Letter of Managed Funds Association (Oct. 12, 2004).

See Hard Times Come To The Hedge Funds, supra note 13 at 10.

The original version of section 203(b) in 1940 also exempted from registration any adviser “whose only clients are investment companies.” Investment Advisers Act, Section 203(b), Pub. L. No. 76-768, 54 Stat. 847, 850 (1940). This language does not, as some commenters have asserted, undermine the Commission's interpretation of section 203(b)(3) with respect to counting the number of clients in a hedge fund. See, e.g., Wilmer Cutler Letter, supra note 142. Even if Congress in 1940 clearly intended, with respect to investment companies, that a legal entity be the client, that does not mean that Congress must have intended the same result with respect to entities—such as hedge funds—that are not investment companies. Moreover, Congress may have included this provision because it believed that, absent an express exemption for investment companies, individual investors might be counted as clients, or may have simply concluded that advisers to entities subject to Title I of the statute they were considering (the Investment Company Act) would not be subject to Title II (the Advisers Act). Title I of the legislation established a new comprehensive scheme for the regulation of investment companies, and Congress may have determined that the investment advisory relationship between an adviser and an investment company would be governed by the new Investment Company Act. See 1940 Senate Hearings, supra note 73, (statement of Senator Boren (“there is a distinct separation of investment advisers under the two different sections of the bill”)).

Although commenters argue, citing certain dictionaries, that “client” has a plain meaning that cannot include passive investors in an entity who are not being advised individually, resort to dictionary definitions is inconclusive. See Webster's Unabridged Dictionary (2nd ed. 1934) (“client” means “one who consults a legal adviser in order to obtain his professional advice or assistance, or submits his cause to his management” (emphasis added.)).

Chevron U.S.A. v. NRDC, 467 U.S. 837, 843-44 (1984). Because the Commission has the inherent authority to interpret the ambiguous language used in section 203(b)(3), the absence of a specific grant of authority in the Advisers Act to define terms (such as is found in the Investment Company Act and other securities statutes) does not limit the scope of our authority. Nor is our authority undermined by the fact that, as explained in the Proposing Release, we are changing our interpretation of the statutory exemption from registration created by section 203(b)(3), as it applies to hedge funds, in light of changed circumstances resulting from the growth of hedge funds. Courts have recognized that agencies have clear authority to change a prior position in light of changed circumstances. See, e.g., American Trucking Assns., Inc. v. Atchison, Topeka & Santa Fe Ry Co., supra note 59; United Video Inc. v. FCC, 890 F.2d 1173, 1181-82 (D.C. Cir. 1989).

Some commenters assert that the method for counting clients of a private fund set forth in rule 203(b)(3)-2 would be inconsistent with the Supreme Court's view of the scope of the Advisers Act expressed in Lowe v. SEC, 472 U.S. 181 (1985). However, Lowe involved a different issue and a different statutory provision—the meaning of the exclusion from the definition of investment adviser in section 202(a)(11)(D) for “the publisher of any bona fide newspaper, news magazine or business of financial publication of general and regular circulation.” 15 U.S.C. 80b-2(11)(d).

See supra note 158.

15 U.S.C. 80b-8d. Congress added section 208(d) to the Advisers Act in 1960, Investment Advisers Act of 1940, Amendment, Pub. L. 86-750, 54 Stat. 847 (1960).

See, e.g., SEC v. Gary A Smith, 1995 Lexis 22352 (S.D. Mich. 1995) (adviser persuaded client to place accounts in trusts to try to avoid Advisers Act regulation).

See Status of Investment Advisory Programs Under the Investment Company Act of 1940, Investment Company Act Release No. 22579 (Mar. 24, 1997) [62 FR 15098 (Mar. 31, 1997)] (adopting rule providing safe harbor from investment company registration for similarly managed accounts).

Similar factors led the Second Circuit to conclude that limited partners of an investment partnership were clients of the general partner/investment adviser for purposes of section 206 of the Act. See Abrahamson v. Fleschner, supra note 157, at 869-70.

See, e.g., Roundtable Transcript of May 14 at 171, supra note (statement of Robert Bernard, Chief of Administration and Finance, RiskMetrics Group) (some investors have the market power to receive full portfolio position disclosure); id. at 177-78 (statement of Robert Bernard). See also Roundtable Transcript of May 15 at 108-09, supra note 17, (statement of Patrick McCarty) (an investor with $25 or $30 million in a fund will have more access than someone investing a small amount).

Ron S. Geffner, Deals on the Side, HEDGEFUNDMANAGER, (US East Coast 2005).

See, e.g., Roundtable Transcript of May 14 at 167, supra note (statement of David Swensen, Chief Investment Officer, Yale University) (Yale sometimes negotiates “deal structures” that differ from the terms set forth in the offering documents); id. at 211-12 (same).

See id. at 68 (statement of Joel Press, Senior Partner, Ernst & Young). See also id. at 56 (statement of Joel Press) (hedge funds may establish separate share classes by type of investor in order to track each investor's return separately). We also note that on June 13, 2002, the Commission issued a Formal Order of Private Investigation in the matter of Investor Protection Implications of Private Investment Fund Growth. In the course of their investigation, our staff reviewed materials that appear to indicate that different investors in a hedge fund may have different investment experiences or may receive different disclosure. Under one limited partnership agreement, for example, limited partners can elect not to participate in the fund's purchase of illiquid assets, which are kept apart from the majority of the fund's assets. Under another limited partnership agreement, as much as 20 percent of the fund's yearly profits, including profits from “hot issue” accounts, could be reallocated to certain limited partners. Marketing material for a third hedge fund stated that investors investing over a certain amount in the fund are provided with additional information about the fund's portfolio holdings.

For convenience, we will use the terms “adviser to a private fund” and “hedge fund adviser” interchangeably. As proposed, rule 203(b)(3)-2 was titled “definition of client for certain private funds.” The rule is now titled “methods for counting clients in certain private funds.” This change does not alter the substance of the rule but is meant to clarify the rule's scope.

As discussed in Section III of this Release, we are implementing a special transition period for the new rule so that advisers to private funds need not look back for the 12-month period when determining their registration obligations as of the compliance date of the new rule.

Commenters asked us to provide further clarification on how hedge fund advisers should count investors when looking through private funds. Comment Letter of Tannenbaum Helpern Syracuse & Hirschtritt LLP (Sept. 14, 2004) (“Tannenbaum Helpern Letter”). If an adviser manages private funds that have, in the aggregate, more than 14 investors, it must register. Thus, an adviser to two private funds, each of which has eight investors, will need to register. Similarly, an adviser must register if it advises a private fund that has 10 investors, and also manages five other portfolios that are not private funds. For counting purposes, an adviser that is required to count the investors in a private fund need not also count the private fund itself.

We remind advisers, however, that, independent of this new rule, the antifraud provisions of the Advisers Act apply to the adviser's relationship with the fund's limited partners. See Abrahamson v. Fleschner, supra note 157.

See section 203A(a)(1)(A) [15 U.S.C. 80b-3a(a)(1)(A)]. The National Securities Markets Improvement Act of 1996 amended the Advisers Act to divide the responsibility for regulating investment advisers between the Commission and the state securities authorities. Section 203A of the Advisers Act [15 U.S.C. 80b-3a] effects this division by generally prohibiting investment advisers from registering with us unless they have at least $25 million of assets under management or advise a registered investment company, and preempting most state regulatory requirements with respect to SEC-registered advisers. See Pub. L. 104-290, 110 Stat. 3416 (1996) (codified in scattered sections of the United States Code).

See Seward & Kissel Letter, supra note 111, Comment Letter of the European Commission (Sept. 15, 2004) (“European Commission Letter”); Comment Letter of the Alternative Investment Management Association Limited (Sept. 15, 2004) (“AIMA Letter”); ABA Letter, supra note 150. Seward & Kissel suggested we apply a $100 million threshold to offshore advisers.

Any adviser whose principal office and place of business is in a state that has enacted an investment adviser statute is subject to this statutory minimum. Any investment adviser whose principal office and place of business is outside the United States, or in Wyoming (the only U.S. state that does not have an adviser statute), is not subject to this minimum and must register with us regardless of the amount of assets it manages. See NSMIA Implementing Release, supra note 10 at Section II.E.

Instruction 5(b) to Part 1 of Form ADV [17 CFR 279.1]

Rule 203(b)(3)-2(a).

Id.

Rule 203(b)(3)-2(a). Rule 205-3(d)(1)(iii) under the Advisers Act permits certain knowledgeable personnel of an investment adviser to pay a performance or incentive fee to the adviser without meeting the net worth or invested assets requirements that would otherwise apply. Similarly, rule 3c-5 under the Investment Company Act [17 CFR 270.3c-5] provides that “knowledgeable employees” of a private investment pool or of its adviser need not be counted in determining the number of beneficial owners of the pool (for 3(c)(1) pools) or in determining whether all investors in the pool are “qualified purchasers” (for 3(c)(7) pools). An adviser could not, however, make a private fund investor a partner in the advisory firm to avoid counting the investor for purposes of the private adviser exemption. See section 208(d) of the Advisers Act.

An adviser is permitted, but not required, to include the value of its family and proprietary securities portfolios in calculating its assets under management under Instruction 5.b(1)(a) to Part 1A of Form ADV. A hedge fund adviser may construe the investments of these inside personnel and their families as proprietary or family assets for purposes of calculating its assets under management. This does not, however, alter the fiduciary obligations of the adviser with respect to those accounts.

The new rule does not require the adviser to the underlying fund to receive information as to the identities of the top tier investors, and does not specify when or how often the underlying hedge fund adviser must assess whether the number of investors in the top tier funds exceeds 14. The underlying adviser need not necessarily receive information as to the precise number of the top tier investors, so long as the underlying adviser can determine, on a periodic ongoing basis, its own registration obligations. Although some commenters expressed concern that advisers to funds of funds would face uncertainty as to their registration obligations, we believe it would be exceedingly rare for the top tier funds to have 14 or fewer investors. Most advisers to underlying hedge funds will not be eligible to rely on the private adviser exemption, absent facts and circumstances that provide assurances to the underlying adviser that no more than 14 investors, in the aggregate, are being served.

Commenters suggested that the adviser to an underlying hedge fund be required to look through its top tier funds only under limited circumstances, such as when the top tier fund holds more than ten percent of the underlying fund. See, e.g., Comment Letter of Dechert LLP (Sept. 15, 2004) (“Dechert Letter”), Comment Letter of Davis Polk & Wardwell (Sept. 15, 2004) (“Davis Polk Letter”); ABA Letter, supra note 150. Such an approach would, however, permit hedge fund managers to avoid registration simply by providing their services to a multitude of investors through, for example, 12 funds of funds, each of which owned eight percent of the underlying fund.

Whether an adviser is “offshore” depends on the location of the adviser's principal office and place of business. See rule 203(b)(3)-1(b)(5).

See, e.g., Financial Services Roundtable Letter, supra note 53; Tannenbaum Helpern Letter, supra note 186. Some commenters raised concerns that regulation under the Advisers Act would conflict with regulations in offshore advisers' home jurisdictions. See Financial Services Roundtable Letter, supra note 53. According to one law firm's analysis, however, registration under the Advisers Act will have little impact on most non-U.S. hedge fund managers: “For unregistered non-U.S. investment managers, it is likely that the impact will be less significant because in most jurisdictions where hedge fund managers are concentrated, including, for example, London, Paris and Frankfurt and other European Union jurisdictions, management of third party assets is generally an activity which requires registration with local regulators and ongoing compliance with minimum operational standards, regardless of the number of “clients” for whom these services are provided. It is likely therefore that most major non-U.S. hedge fund managers that will be affected by the SEC's recommendations will already be complying in their home jurisdictions with broadly similar requirements to those the Staff now seeks to impose.” See Shearman & Sterling, SEC Report: Implications of the Growth of Hedge Funds, Jan. 2004, available in File No. S7-30-04.

So that our oversight of offshore advisers can be conducted effectively and efficiently in light of potential overlap with foreign regimes, we have asked our Division of Investment Management, our Office of Compliance Inspections and Examinations, and our Office of International Affairs to explore ways to obtain and share information with foreign authorities with oversight of hedge advisers that may register with the SEC.

As discussed in Section II.F. of this Release, new rule 203(b)(3)-2 and rule 203(b)(3)-1 are designed to work together. Once the offshore adviser looks through the private fund as required under rule 203(b)(3)-2, rule 203(b)(3)-1(b)(5) provides that only U.S. clients must be counted towards the private adviser exemption.

Commenters asked that, because rule 203(b)(3)-1 speaks only to residents, we provide further guidance on when a client, particularly a client that is not a natural person, should be considered a U.S. client. Several commenters suggested that the Advisers Act should look to the definition of “U.S. person” in Regulation S under the Securities Act of 1933. See 17 CFR 230.902. Regulation S is designed for use in transactions, not ongoing advisory relationships, and its use in this context raises larger issues that we cannot address in this rulemaking. Until the Commission reconsiders this question, however, we would not object if advisers looked (i) in the case of individuals to their residence, (ii) in the case of corporations and other business entities to their principal office and place of business, (iii) in the case of personal trusts and estates to the rules set out in Regulation S, and (iv) in the case of discretionary or non-discretionary accounts managed by another investment adviser to the location of the person for whose benefit the account is held.

The offshore adviser would not have to register, however, if it were eligible for some other exemption from registration.

Rule 203(b)(3)-1(b)(7). If, however, a non-U.S. investor transfers his interest to a U.S. investor, the adviser should count the transferee as a U.S. client.

Comment Letter of International Bar Association (Sept. 14, 2004) (“International Bar Letter”), ABA Letter, supra note 150, AIMA Letter, supra note 189.

Commenters pointed out that, because of provisions in the U.S. tax laws, U.S. investors in offshore hedge funds are likely to be tax-exempt investors such as pension and benefit plans subject to the Employee Retirement Income Security Act of 1974 (“ERISA”) [ 29 U.S.C. 1001 et seq.]. Many hedge funds permit no more than 25 percent of the fund's assets to be held by pension plans subject to ERISA in order to prevent the assets of the fund from being deemed “plan assets” under ERISA. See 29 CFR 2510.3-101 (Department of Labor regulation deems participation by plan investors of 25 percent or more in the unregistered securities of an entity to be significant which would then trigger certain ERISA limitations on the hedge fund). Accordingly, it may be unusual for these funds to have more than 25 percent U.S. ownership.

Rule 203(b)(3)-1(d)(3). Commenters supported this exception.

Section 7(d) of the Investment Company Act [15 U.S.C. 80a-7(d)] generally prohibits a foreign investment company from publicly offering its securities in the United States unless registered with us. That provision does not preclude these foreign investment companies from making private offerings in the United States. Resale of Restricted Securities, Investment Company Act Release No. 17452 (Apr. 23, 1990) [55 FR 17933 (Apr. 30, 1990)]. See also Touche Remnant & Co., SEC Staff No-Action Letter (Aug. 27, 1984); Goodwin, Procter & Hoar, SEC Staff No-Action Letter (Feb. 28, 1997). Our staff has also provided no-action relief to address circumstances where U.S. persons are shareholders of foreign investment companies as a result of, for example, relocating to the United States. See, e.g., Investment Funds Institute of Canada, SEC Staff No-Action Letter (Mar. 4, 1996).

This clarification responds to an issue raised by the European Commission. See European Commission Letter, supra note 189. Some commenters asked whether all funds listed on an offshore securities exchange were offshore public funds. See AIMA Letter, supra note 189; Coudert Letter, supra note 152. We note that listing criteria in some jurisdictions may be distinct from criteria for public offerings, and we cannot provide guidance in this area at this time. The European Commission also pointed out that some offshore public funds may be authorized for public sale in multiple countries pursuant to harmonized regulations, while others may be sold publicly only in individual countries. A fund would qualify for this exception so long as it is regulated as a public investment company in at least one of the jurisdictions in which it may be offered to the public.

We are aware that, in some jurisdictions, hedge funds may be publicly offered. Such funds would not be public investment companies for purposes of this rule. Whether a particular fund is a public investment company will turn on, among other things, how it is known in those other jurisdictions.

Rule 203(b)(3)-2(c). This provision applies in the case of an adviser whose principal office and place of business is outside the United States, if the fund is organized under the laws of a country other than the United States. The proposal looked instead to the principal office and place of business of the fund, but as one commenter noted, a fund as a passive vehicle typically has no offices. ABA Letter, supra note 150.

This policy was first set forth in a staff letter from our Division of Investment Management, in which Division staff stated that they would not recommend to the Commission enforcement action against an offshore fund adviser under such circumstances. See Uniao de Banco de Brasileiros S.A., SEC Staff No-Action Letter (July 28, 1992) (“Unibanco letter”).

It has been estimated that 70 percent of hedge funds are organized offshore. See Bernstein 2003 Report, supra note at 11.

It is not uncommon for U.S. investors to acquire interests in an offshore hedge fund that has few connections to the United States other than the investors (or the securities in which they invest). The laws governing such a fund would likely be those of the country in which it is organized or those of the country in which the adviser has its principal place of business. U.S. investors in such a fund generally would not have reasons to expect the full protection of the U.S. securities laws. See Offshore Offers and Sales, Securities Act Release No. 6863 (Apr. 24, 1990) [55 FR 18306 (May 2, 1990)]. Moreover, as a practical matter, U.S. investors may be precluded from an investment opportunity in offshore funds if their participation resulted in the full application of the Advisers Act and our rules.

Dechert Letter, supra note 197, Comment Letter of White & Case LLP (Aug. 31, 2004) (“White & Case Letter”); Comment Letter of Jonathan Baird (Aug. 11, 2004) (“ Baird Letter”); ICI Letter, supra note 48; Tannenbaum Helpern Letter, supra note 186, European Commission Letter, supra note 189, Davis Polk Letter, supra note 197, AIMA Letter, supra note 189; Comment Letter of the Association of the Bar of the City of New York Committee on Private Investment Funds (Sept. 15, 2004) (“NYC Bar Private Funds Letter”); ABA Letter, supra note 150.

One commenter asked whether we would view it as misleading for an offshore adviser to represent itself as registered with the Commission under the Advisers Act, given that it is not required under the rule to comply with many provisions of the Act with respect to its offshore clients. NYC Bar Private Funds Letter, supra note 214. We note that offshore advisers seeking no-action relief from our staff have undertaken not to represent themselves to offshore clients as registered with us. E.g., Royal Bank of Canada, SEC Staff No-Action Letter (June 3, 1998). We are not, at this time, prohibiting offshore advisers from representing themselves as SEC-registered advisers, but we remind them that they remain subject to the Act's antifraud provisions and that substantial clarification and disclosure may be necessary to make the representation not misleading.

Our staff has provided guidance, in a series of no-action letters, regarding the recordkeeping obligations of registered advisers that are located offshore. Under that analysis, the registered adviser must, in order to rely on the no-action relief, comply with our recordkeeping rules, other than (1) rules 204-2(a)(3) and (7) with respect to transactions involving offshore clients that do not relate to advisory services performed by the registered adviser on behalf of United States clients or related securities transactions; and (2) rules 204-2(a)(8), (9), (10), (11), (14), (15) and (16) and 204-2(b) with respect to transactions involving, or representations or disclosures made to, offshore clients. See, e.g., Royal Bank of Canada, supra note 215. In the context of rule 203(b)(3)-2, an offshore adviser to an offshore private fund would treat the fund as its offshore client for purposes of its recordkeeping requirements.

During an examination, the registered offshore adviser must provide to our staff any and all records required to be kept under our rules as well as any records the adviser keeps under foreign law. Id. Section 204 of the Act [15 U.S.C. 80b-4] authorizes us to examine all records of any registered adviser.

17 CFR 275.206(4)-7.

17 CFR 275.206(4)-2.

17 CFR 275.206(4)-6.

In addition, we would not require an offshore adviser to deliver a written disclosure brochure to its offshore clients (or to any investors in an offshore private fund it advises) under rule 204-3 [17 CFR 275.204-3], although the adviser does have a fiduciary duty to provide those clients with full and fair disclosure of conflicts of interest. We would not require an offshore adviser's contracts with its offshore clients, including an offshore private fund, to include certain provisions that would otherwise be required by section 205. Moreover, with respect to an offshore fund, an adviser, whether located within or without the United States, is not subject to the prohibition on performance fees contained in section 205; section 205(b)(5) makes that prohibition inapplicable to an advisory contract with a person that is not a resident of the United States. [15 U.S.C. 80b-5]. Thus, a registered adviser can charge performance fees to an offshore fund regardless of whether the fund has U.S. investors. We would not apply section 206(3)'s restrictions to an offshore adviser's principal transactions with offshore clients. [15 U.S.C. 80b-6(3)]. We would also not subject an offshore adviser to our rules governing adviser advertising [17 CFR 275.206(4)-1], or cash solicitations [17 CFR 275.206(4)-3] with respect to offshore clients.

A registered offshore adviser must, of course, comply with all of the Advisers Act and our rules with respect to any U.S. clients it may have.

17 CFR 275.204A-1.

Our approach to defining the scope of rule 203(b)(3)-2 is similar to that taken recently by the Department of Treasury in defining the scope of its proposed rule requiring “private investment companies” to adopt anti-money laundering programs. See Financial Crimes Enforcement Network; Anti-Money Laundering Programs for Unregistered Investment Companies, Department of the Treasury Release [67 FR 60617 (Sept. 26, 2002)]. Like the Treasury Department, we have tried to keep the definition simple, and provide a “bright line” indicator of when an adviser must look through a client that is a legal organization.

Private equity funds concentrate their investments in unregistered (and typically illiquid) securities. They typically are long-term investments providing for liquidation at the end of a term specified in the fund's governing documents. Private equity investors typically commit to invest a certain amount of money with the fund over the life of the fund, and make their contributions in response to “capital calls” from the fund's general partner. Private equity funds offer little, if any, opportunity for investors to redeem their investments.

Venture capital funds are generally organized to invest in the start-up or early stages of a company. Venture capital funds have the same features that distinguish private equity funds generally from hedge funds, such as capital contributions over the life of the fund and the long-term nature of the investment. A venture capital fund typically seeks to liquidate its investment once the value of the company increases above the value of the investment.

A few commenters suggested that the rule distinguish hedge funds from other privately offered investment pools on the basis of their investment strategies or portfolio composition. See, e.g., Madison Capital Letter, supra note 51. We have not adopted such an approach because we are concerned that it could serve to chill advisers' use of certain investment strategies solely in order to avoid registration under the Advisers Act, and might possibly negatively affect the markets.

Rule 203(b)(3)-1(d)(1)(i). Section 3(c)(1) excepts from the definition of investment company, an issuer the securities (other than short-term paper) of which are beneficially owned by not more than 100 persons and that is not making or proposing to make a public offering of its securities. An issuer that is organized in a country other than the United States is not subject to the 100-investor limitation of section 3(c)(1) with respect to its beneficial owners who are non-U.S. persons. Section 3(c)(7) excepts from the definition of investment company, an issuer the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers and that is not making or proposing to make a public offering of its securities. An issuer that is organized in a country other than the United States is not subject to the qualified purchaser limitation of section 3(c)(7) with respect to its owners who are non-U.S. persons. Under certain conditions, an issuer organized in a country other than the United States may make a private placement in the U.S. in accordance with Regulation D concurrently with an offering in another country in accordance with Regulation S under the Securities Act of 1933 without integrating the two offerings for purposes of determining whether the issuer complies with section 3(c)(1) or 3(c)(7) or has made a public offering in contravention of section 7(d) of the Investment Company Act (prohibiting investment companies organized outside of the United States from making a public offering). Statement of the Commission Regarding Use of Internet Web Sites to Offer Securities, Solicit Securities Transactions or Advertise Investment Services Offshore, Securities Act Release No. 7516 (Mar. 23, 1998); See also Touche Remnant & Co., SEC Staff No-Action Letter (Aug. 27, 1984) and Goodwin, Proctor & Hoar, SEC Staff No-Action Letter (Feb. 28, 1997) (addressing public offerings for purposes of section 7(d)). Cf. Resale of Restricted Securities; Changes to Method of Determining Holding Period of Restricted Securities Under Rules 144 and 145, Securities Act Release No. 33-6862 (Apr. 30, 1990), at Section II.F. Our staff's no-action letter, The France Growth Fund, Inc., SEC Staff No-Action Letter (July 15, 2003), is superseded to the extent that it is inconsistent with this Release.

An offshore hedge fund in which U.S. persons invest will ordinarily be a section 3(c)(1) or 3(c)(7) issuer because it makes a private offering (if any) in the U.S., and has 100 or fewer beneficial owners that are U.S. persons or requires all of its owners who are U.S. persons to be qualified purchasers, respectively.

These companies, as opposed to other entities, by definition, engage in significant securities related activities. See sections 3(a) and 3(b) of the Investment Company Act. Moreover, 3(c)(1) and 3(c)(7) funds invest in the context in which they deal privately with investors because both provisions require that the fund not engage in a public offering.

Commenters asked whether the rule would require a U.S. adviser to look through an offshore pooled investment vehicle whose investors are all non-U.S. persons. If interests in the pool are offered only to non-U.S. investors, it is unlikely that the pool would be relying on the exceptions in either section 3(c)(1) or section 3(c)(7). If the pool does not rely on one of those exceptions, the pool is not a private fund under the rule, and thus only the pool itself would count as a single client.

Many offshore hedge funds are organized as master-feeder structures in which an offshore adviser organizes a “master” fund interests in which are purchased by multiple “feeder funds.” The feeder funds seek to achieve their investment objectives solely by investing in the master fund and thus the feeder is a conduit that provides different investors access to the master fund. One feeder fund may be organized as a corporation and offered solely to non-U.S. investors, while another may be organized as a limited partnership in a foreign jurisdiction offering its shares exclusively to more than 14 U.S. investors. See Thomas P. Lemke et al, Hedge Funds and Other Private Funds: Regulation and Compliance (2004-05) at 19. The feeder fund is a private fund under rule 203(b)(3)-1(d); interests in the feeder are sold directly to U.S. investors, and thus the feeder must rely on either section 3(c)(1) or 3(c)(7) to avoid being subject to the Investment Company Act. The adviser to the master fund must look through the master fund as well as the feeder in order to count U.S. investors as clients, so that it is not violating section 208(d) of the Act by doing indirectly through the master what it could not do if it provided its advice directly to the feeder fund. See discussion supra note 176.

Comment Letter of David Schroll (July 27, 2004) (“Schroll Letter”); Proskauer Letter, supra note 51; Comment Letter of Guy Judkowski (July 27, 2004) (“Judkowski Letter”); Seward & Kissel Letter, supra note 111; Madison Capital Letter, supra note 51; Tudor Letter, supra note 53; Davis Polk Letter, supra note 197; Financial Services Roundtable Letter, supra note 53; Comment Letter of Kleinberg, Kaplan, Wolff & Cohen, P.C. (Sept. 15, 2004) (“Kleinberg Letter”).

See supra Section II.B.8 of this Release. Further, Congress chose to not to exempt 3(c)(7) fund advisers from the Advisers Act. An adviser that manages more than fourteen 3(c)(7) funds is required to register and is subject to all provisions of the Advisers Act, yet the investors in those funds are no less sophisticated than other 3(c)(7) fund investors. Also, Congress excepted 3(c)(7) fund advisers from performance fee restrictions under section 205 of the Act, which applies only to advisers who are not otherwise exempt from registration under section 203(b). See section 205(b)(4) [15 U.S.C. 80b-5(b)(4)].

Rule 203(b)(3)-1(d)(1)(ii). Two commenters suggested we shorten the period while another suggested it be longer. See AIMA Letter, supra note 189; Seward & Kissel Letter, supra note 111; Comment Letter of UnFarallon Coalition (Sept. 14, 2004) (“UnFarallon Letter”). Research has shown that hedge funds’ average lock-up period is 12 months. Bernstein 2003 Report, supra note 24, at 5. We believe a two-year period, therefore, would include most hedge funds as private funds, and we are adopting a redemption test of two years as proposed.

Funds could use a “first in, first out” for determining the age of purchases and capital contributions.

Private funds operate in this respect similarly to an account an investor maintains with an adviser.

Hedge funds generally offer semi-annual, quarterly, or monthly liquidity terms to their investors. Because liquidity is important to hedge fund investors, some hedge fund advisers offer certain investors “side letter agreements” to provide shorter liquidity terms than other investors in the same fund may receive. See Alexander M. Ineichen, Funds of Hedge Funds: Industry Overview, 4 J. Wealth Mgmt. 47 (Mar. 22, 2002); Ron S. Geffner, Deals on the Side, HEDGEFUNDMANAGER, U.S. East Coast 2005, at 22-23. An investment pool cannot use side letters to bypass the two-year redemption test. That is, if the pool uses side letters to provide some, but not all, investors the opportunity to redeem shares within two years, the pool would meet the definition of a private fund.

This provision is also designed to prevent certain structured finance vehicles from being included as “private funds.” See, e.g., rule 3a-7(a) under the Investment Company Act [17 CFR 270.3a-7(a)] (exemption from Investment Company Act is not available to structured finance vehicle issuing redeemable securities); see also Comment Letter of Chapman and Cutler LLP (Sept. 15, 2004) (expressing concerns that some structured finance vehicles would inappropriately be deemed to be private funds).

See, e.g., SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, Litigation Release No. 17303 (Jan. 10, 2002) and supra note 97; In the Matter of Michael T. Higgins, supra note 99; SEC v. David M. Mobley, Sr., et al., supra note 99; SEC v. Michael W. Berger, Manhattan Capital Management Inc., supra note 99; SEC v. Todd Hansen and Nicholas Lobue, Litigation Release No. 17299 (Jan. 9, 2002).

We are currently pursuing actions in which we allege hedge fund advisers lulled investors into keeping their assets in the hedge fund. See, e.g., SEC v Anthony P. Postiglione, Jr., et al., Litigation Release No. 18824 (Aug. 9, 2004).

Moreover, periodic redemption rights offered by hedge funds provide the hedge fund investors with a level of liquidity that allows the investor to withdraw a portion of his or her assets, controlled by the adviser, or to terminate the relationship with the hedge fund adviser and choose a new adviser. The ability to terminate the relationship with an adviser and choose a new one, or to withdraw a portion of one's investment after a relatively short time period, is consistent with the notion that hedge fund advisers are effectively providing advisory services to the fund's investors. As a result, the redeemability feature of the definition of private fund will promote the purposes of the Act by applying the rule to those relationships that the Act was designed to address.

E.g., NYC Bar Private Funds Letter, supra note 214. Some commenters expressed concern that hedge fund advisers would extend their lock-up periods beyond two years in order to avoid registration. E.g., Comment Letter of the Greenwich Roundtable (Sept. 15, 2004). Others felt that the two-year test drew an appropriate line between hedge funds and private equity or venture capital funds. See Comment Letter of National Venture Capital Association (Sept. 15, 2004) (“NVCA Letter”) (“As a practical means of exempting venture capital from the proposed rule's definition of ‘private fund,’ two years is appropriate.”). We will continue to monitor developments regarding this aspect of the new rule and whether it continues effectively to distinguish hedge funds from private equity and venture capital funds.

Rule 203(b)(3)-1(d)(2)(i).

See Davis Polk Letter, supra note 214, NYC Bar Private Funds Letter, supra note 150, ABA Letter, supra note 150. Many partnership agreements provide the investor the opportunity to redeem part or all of its investment, for example, in the event continuing to hold the investment became impractical or illegal, in the event of an owner's death or total disability, in the event key personnel at the fund adviser die, become incapacitated, or cease to be involved in the management of the fund for an extended period of time, in the event of a merger or reorganization of the fund, or in order to avoid a materially adverse tax or regulatory outcome. Similarly, some investment pools may offer redemption rights that can be exercised only in order to keep the pool's assets from being considered “plan assets” under ERISA. Offering redemption rights that apply only in these types of circumstances will not make the fund a “private fund” under the new rule.

These are distributions, as distinguished from redemptions initiated by the investor. Similarly, an investor's transfer of his interest to, for example, a new limited partner in a secondary market transaction will not be considered a redemption.

Proposed rule 203(b)(3)-1(d)(2)(ii). Though we proposed this exception only for interests acquired with reinvested dividends, commenters noted that venture capital and private equity funds are more likely to distribute capital gains than declare dividends.

If interests in an investment pool are offered based on the investment advisory skills, ability or expertise of the pool's investment adviser, then the pool is a private fund and all advisers to the pool, including subadvisers, must look through it to count owners as clients for purposes of the private adviser exemption. Advisers may not circumvent the rule by delegating the advisory function to subadvisers, including subadvisers that might not be identified in the fund's offering materials, or by establishing a “manager of managers” structure.

See also Roundtable Transcript of May 14 at 167-68, supra note 17 (statement of David Swensen, Chief Investment Officer, Yale University) (investor looks for “the character, the intelligence, the integrity, the creativity, and market savvy” of the fund adviser, and the most important criterion when making an investment decision is the character and quality of the investment adviser).

This is particularly true when this attribute is combined with the redeemability feature discussed earlier, such that an investment in a hedge fund more closely resembles an advisory account. It is also worth noting in this regard that section 203(b)(3) of the Advisers Act [15 U.S.C. 80b-3(b)(3)] specifically excludes an adviser from relying on the exemption, even if it has fewer than 15 clients, if it holds itself out generally to the public as an investment adviser.

Rule 203(b)(3)-1(b)(6). We are also adopting, as proposed, non-substantive changes to the wording of several other paragraphs of rule 203(b)(3)-1 to clarify those sections.

Rule 203(b)(3)-1(a)(2)(i).

For example, particularly paragraph (a)(1) of rule 203(b)(3)-1 allows a “single client” to encompass (i) a natural person, (ii) his or her minor children, (iii) his or her relatives, spouse, and relatives of spouse who share the same principal residence, as well as (iv) any accounts or trusts of which the only primary beneficiaries are the foregoing persons. In addition, if a given individual invests in two private funds advised by the same adviser, that individual need be counted only once towards the 14-client threshold.

Several commenters suggested that new rule 203(b)(3)-2 contain a special provision for limited partnerships owned or controlled primarily by members of a single family. See Comment Letter of Paul, Hastings, Janofsky & Walker LLP (Sept. 10, 2004) (“Paul Hastings Letter”); Comment Letter of Skadden, Arps (Sept. 14, 2004) (“Skadden Letter”), Kynikos Letter, supra note 80, ABA Letter, supra note 150. Others suggested we adopt a provision declaring that interests in family limited partnerships are not offered based on the expertise of the adviser. See Davis Polk Letter, supra note 197, Comment Letter of William S. McGinness, Jr. (July 26, 2004). This latter suggestion may be true in some circumstances, but there may be other cases in which, for example, a family group has engaged an outside adviser and interests in the family vehicle are offered to family members based on the expertise of the adviser. We believe that rule 203(b)(3)-1(a)(1) already affords family office advisers considerable flexibility before they reach fifteen clients. We also note that we have granted exemptive relief, on application, to a number of family office advisers. E.g., Bear Creek Inc., Investment Advisers Act Release No. 1931 (Mar. 9, 2001) [66 FR 15150 (Mar. 15, 2001)] (notice); Moreland Management Co., Investment Advisers Act Release No. 1700 (Feb. 12, 1998) [63 FR 8710 (Feb. 20, 1998)] (notice). A further exception for family limited partnerships is outside the scope of this rulemaking.

An adviser to a hedge fund underlying a fund of funds must, as discussed earlier, apply new rule 203(b)(3)-2 to look through the top tier fund and count that fund's investors as clients for purposes of the private adviser exemption. Once the underlying adviser has looked through the layers of private funds, however, it may then apply the provisions of rule 203(b)(3)-1(a)(1) to those investors for counting purposes.

Under rule 204-2(a)(16), a registered investment adviser that makes claims concerning its performance track record must keep “[a]ll accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for or demonstrate the calculation of the performance or rate of return of any or all managed accounts or securities recommendations in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons (other than persons connected with such investment adviser); provided, however, that, with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client's account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.” The supporting records must be retained for a period of five years after the performance information is last used. Rule 204-2(e)(3). Thus, if a registered adviser promotes its 20-year performance record in 2004, it must continue to keep its supporting records for its 1984 performance through 2009—five years after the last time that 1984 performance is included.

Rule 204-2(e)(3)(ii). Commenters pointed out that hedge fund advisers may manage other clients' assets.

Commenters generally supported this transitional exemption for hedge fund advisers' past performance records, in order to avoid placing these new registrants at a competitive disadvantage in promoting the returns they have earned, in some cases over many years. See Comment Letter of Cumberland Associates LLC (Sept. 9, 2004) (“Cumberland Letter”), Comment Letter of James E. Mitchell (Sept. 1, 2004) (“Mitchell Letter”), ICAA Letter, supra note 47, Davis Polk Letter, supra note 197; ABA Letter, supra note 150. Three commenters suggested that we require hedge fund advisers to place a legend on any marketing materials that contained performance claims for which the adviser did not maintain all required records. CFA Institute Letter, supra note 47; ICAA Letter, supra note 47, UnFarallon Letter, supra note 230. The final rule does not impose such a requirement, but we caution hedge fund advisers that they remain, as they were prior to their registration, subject to the Advisers Act's antifraud provisions with respect to their marketing materials. One commenter opposed the exemption.

Rule 204-2(e)(3)(ii).

Section 204 of the Act [15 U.S.C. 80b-4] generally subjects records of registered investment advisers to examination by the Commission.

We include private funds for which the adviser's related person (as defined in Form ADV) acts as general partner, managing member, or in a similar capacity, because many hedge fund advisers establish a separate special purpose vehicle to be named as the fund's general partner.

Rule 204-2(l). One commenter described this amendment as a “necessary requirement.” CFA Institute Letter, supra note 47. The rule does not require that the adviser maintain duplicate books and records for the funds, nor that a registered private fund adviser be the party to keep the books and records of the private funds in question. Because the private funds' records will be deemed to be records of the adviser, however, our examination staff will have access to them when they examine the adviser.

The rule applies to related person general partners only when the adviser has an advisory relationship with the fund in question. It does not, as one commenter was concerned, apply to every related general partnership in a large financial complex.

Rule 205-3 permits registered advisers to charge performance fees that would otherwise be prohibited by section 205(a) [15 U.S.C. 80b-5(a)]. Registered advisers are not prohibited from charging performance fees to 3(c)(7) funds, investors in which must all be “qualified purchasers.” Section 205(b)(4) [15 U.S.C. 80b-5(b)(4)].

Rule 205-3(a). The adviser to a 3(c)(1) fund must look through the fund to determine whether all investors are qualified clients. See rule 205-3(b). A “qualified client” under rule 205-3 is: (i) A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser; (ii) A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either: (A) Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into; or (B) Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 [15 U.S.C. 80a-2(a)(51)(A)] at the time the contract is entered into; or (iii) A natural person who immediately prior to entering into the contract is: (A) An executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser; or (B) An employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company for at least 12 months. Rule 205-3(d)(1).

In the absence of relief, the newly-registered adviser would have to either force the non-qualified client out of the 3(c)(1) fund or restructure its fee so that the non-qualified client is not paying the performance-based component of the fee.

Proposed rule 205-(3)(c)(2) (grandfathering investors in “private funds”).

NYC Bar Private Funds Letter, supra note 214.

One hedge fund adviser suggested that we also allow grandfathered investors to open new accounts in the hedge fund in which they were invested, and two other commenters suggested we also allow grandfathered investors to invest in new funds advised by the same hedge fund adviser. Davis Polk Letter, supra note 197, ABA Letter, supra note 150. These suggestions go significantly beyond our oxbjective in proposing the grandfathering provision, which was to avoid disrupting existing business arrangements.

An adviser acting as general partner to a pooled investment vehicle it manages, including a hedge fund, has custody of the pool's assets. Rule 206(4)-2(c)(1)(iii). The adviser may satisfy its obligation to deliver custody account information to investors by distributing the pool's audited financial statements to investors. Rule 206(4)-2(b)(3). The current rule gives advisers 120 days from the pool's fiscal year-end to distribute the financial statements. Id.

A “fund of funds” under the amended rule is any limited partnership (or limited liability company or other type of pooled investment vehicle) that invests at least 10 percent of its total assets in other pooled investment vehicles that are not related persons of the fund of funds, or related persons of the adviser or general partner of the fund of funds. Rule 206(4)-2(c)(4). Where the underlying funds are related to the fund of funds, the fund of funds should have ample opportunity to coordinate its audit with that of the underlying funds.

Dechert Letter, supra note 197; Renaissance, Alternative Investment Group Letter, supra note 47; Comment Letter of Stroock/Credit Suisse Union Bancaire (Sept. 2, 2004) (“Stroock Letter”); Katten Muchin Letter, supra note 127; Van Hedge Letter, supra note 45; Coudert Letter, supra note 152; Comment Letter of Price Meadows (Sept. 15, 2004) (“Price Meadows Letter”); Comment Letter of Silver Creek (Sept. 15, 2004) (“Silver Creek Letter”).

The ABA Letter, supra note 150, and NYC Bar Private Funds Letter, supra note 214, both raised this specific concern. Section 222(d) of the Advisers Act [15 U.S.C. 80b-18a(d)] provides that a state may not require an adviser to register with its state securities authority unless the adviser has a place of business located within the state or has had, during the preceding 12-month period, at least 6 clients who are residents of that state. Rule 222-2 [17 CFR 275.222-2] provides that an adviser may rely on rule 203(b)(3)-1 when counting clients for purposes of the de minimis standard.

17 CFR 275.203a-3. See NYC Bar Private Funds Letter, supra note 214.

The amendment makes new rule 203(b)(3)-1(a)(6) inapplicable in the context of rules 203A-3 and 222-2. Because new rule 203(b)(3)-1(a)(6) does not apply, advisers are free to look to rule 203(b)(3)-1(a)(2)(i) with respect to private funds.

CFA Institute Letter, supra note 47. Because advisers' responses to Form ADV are made available to the investing public on the Internet through the Investment Adviser Public Disclosure system, one commenter asked that we confirm that hedge fund advisers would not be disqualified from relying on section 4(2) of the Securities Act of 1933 [15 U.S.C. 77d(2)] or on rule 506 [17 CFR 230.506] thereunder, both of which are unavailable in the event of a public offering, solely as a result of the private fund being identified through the IAPD. See ABA letter, supra note 150. The mere identification of a private fund through the IAPD does not render section 4(2) or rule 506 unavailable. We note that Form ADV already calls for registered advisers to identify the private investment pools they manage; this information appears on the IAPD for the estimated 40 to 50 percent of hedge fund advisers that are already registered with us.

Commenters expressing a view on the compliance period generally suggested hedge fund advisers would require one year to begin complying as registered advisers under the Advisers Act and its rules. Dechert Letter, supra note 197, Seward & Kissel Letter, supra note 111, Davis Polk Letter, supra note 197, AIMA Letter, supra note 189, Coudert Letter, supra note 152; NYC Bar Private Funds Letter, supra note 214, NYC Bar Futures Committee Letter, supra note 127, ABA Letter, supra note 150.

The private adviser exemption requires that the adviser count all persons who have been clients at any time during the preceding 12 months. At the suggestion of a commenter, we will apply the new counting rule only prospectively, without regard to this “look back” provision for the period leading up to the compliance date. Coudert Letter, supra note 152.

Under the Advisers Act and our rules, registered investment advisers must, for example, have policies in place to ensure compliance with the Act and its rules (rule 206(4)-7), including policies to prevent misuse of material nonpublic information (section 204A [15 U.S.C. 80b-4a]) and policies to ensure that (if they vote client securities) client securities are voted in the best interest of the client (rule 206(4)-6). Registered advisers must also have in place a code of ethics applicable to their supervised persons, which code must require access persons to submit reports of personal securities transactions and holdings (rule 204A-1). We understand that, in many advisory firms, access persons use their year-end brokerage statements to compile their securities holding reports; accordingly, we have set the compliance date for the new rules so as to allow sufficient time for hedge fund advisers' access persons to receive their brokerage statements for the period ended December 31, 2005 and to submit their securities holdings reports before the compliance date. For this reason, we are hereby extending the compliance date for rule 204A-1 from January 7, 2005 to February 1, 2005. See Investment Adviser Codes of Ethics, Investment Advisers Act Release No. 2256 (July 2, 2004) [69 FR 41695 (July 9, 2004)] at Section III.

Rule 206(4)-7. Several commenters seemed to believe our rule would require them to hire a new executive to serve as chief compliance officer. As we have explained previously, the rule does not require an adviser to hire new staff, only to designate the person within the firm that is primarily responsible for compliance.

Rule 206(4)-2.

Section 205(a)(1) and rule 205-3.

Rule 204-2.

Rule 206(4)-1.

Rule 206(4)-3.

Similarly, advisers applying for registration with the Commission after the form has incorporated the amendments must respond to Item 7.B of Part 1A as amended.

See supra notes 46-50 and accompanying text.

See supra note 51 and accompanying text.

See Section II.B.2 of this Release. We received comments specifically focusing on these benefits under the rule. See, e.g., ICAA Letter, supra note 47. One commenter asserted it may be impossible for the Commission to identify potentially harmful compliance problems at an early stage absent the ability to examine hedge fund advisers. ICI Letter, supra note 48.

See Section II.B.3 of this Release. Commenters also viewed this screening function as an important benefit for investors. See, e.g., Vantis July Letter, supra note 106 (registered hedge fund adviser stated that lack of scrutiny of hedge fund advisers has led to the industry attracting “unsavory characters”); Ohio PERS Letter, supra note 47; ICI Letter, supra note 48; IMCA Letter, supra note 48.

SEC v. EPG Global Private Equity Fund, Litigation Release No. 18577 (Feb. 17, 2004); SEC v. Millennium Capital Hedge Fund, L.P., Millennium Capital Group, LLC, and Andreas F. Zybell, supra note 99; In the Matter of John Christopher McCamey and Sierra Equity Partners, LP, Securities Exchange Act Release No. 48917 (June 18, 2003).

SEC v. Haligiannis, et al, Litigation Release No. 18853 (Aug. 25, 2004); SEC v. Scott B. Kaye, et al., Litigation Release No. 18845 (Aug. 24, 2004); SEC v. Gary M. Kornman, Litigation Release No. 18836 (Aug. 18, 2004); SEC v. Anthony P. Postiglione, Jr., et al., supra note 236; In the Matter of Samer M. El Bizri and Bizri Capital Partners, Inc., supra note 99, SEC v. Daniel D. Dyer and Oxbow Capital Partners, LLC, Litigation Release No. 18719 (May 19, 2004); SEC v. J. Robert Dobbins, Dobbins Capital Corp., Dobbins Offshore Capital LLC, Dobbins Partners, L.P., and Dobbins Offshore, Ltd., Litigation Release No. 18634 (Mar. 23, 2004); SEC v. Patrollers Capital Fund and Franklin S. Marone, Litigation Release No. 18601 (Feb. 27, 2004); SEC v. Darren Silverman and Matthew Brenner, Litigation Release No. 18597 (Feb. 25, 2004); In the Matter of Nevis Capital Management, LLC, David R. Wilmerding, III and Jon C. Baker, supra note 94; In the Matter of Robert T. Littell and Wilfred Meckel, Investment Advisers Act Release No. 2203 (Dec. 15, 2003); SEC v. Adam G. Kruger and Kruger, Miller, and Tummillo, Inc., Litigation Release No. 18473 (Nov. 20, 2003); SEC v. Koji Goto, Litigation Release No. 18456 (Nov. 14, 2003); SEC v. John F. Turant, Jr., Russ R. Luciano, JTI Group Fund, LP, J.T. Investment Group, Inc., Evergreen Investment Group, LP, and New Resource Investment Group, Inc., Litigation Release No. 18351 (Sept. 15, 2003); SEC v. Michael Batterman, Randall B. Batterman III, and Dynasty Fund, Ltd., et al., Litigation Release No. 18299 (Aug. 20, 2003); SEC v. Ryan J. Fontaine and Simpleton Holdings Corporation a/k/a Signature Investments Hedge Fund, supra note 11; In the Matter of Ascend Capital, LLC, Malcolm P. Fairbairn, and Emily Wang Fairbairn, Investment Advisers Act Release No. 2150 (July 17, 2003); SEC v. Beacon Hill Asset Management LLC, et al., supra note 97; SEC v. J. Scott Eskind, Lorus Investments, Inc., and Capital Management Fund, Limited Partnership, supra note 100; SEC v. Michael L. Smirlock and LASER Advisers, Inc., Litigation Release No. 17630 (July 24, 2002); SEC v. Schwendiman Partners, LLC, Gary Schwendiman, and Todd G. Schwendiman, supra note 94; SEC v. Von Christopher Cummings, Paramount Financial Partners, L.P., Paramount Capital Management, LLC, John A. Ryan, Kevin L. Grandy and James Curtis Conley, Litigation Release No. 17598 (July 3, 2002); SEC v. House Asset Management, L.L.C., House Edge, L.P., Paul J. House, and Brandon R. Moore, supra note 97; In the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, supra note 94; SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, supra note 97; In the Matter of Zion Capital Management LLC, and Ricky A. Lang, supra note 101; SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, supra note 97; SEC v. Vestron Financial Corp., et al., supra note 97; SEC v. Edward Thomas Jung, et al., supra note 97; SEC v. Burton G. Friedlander, supra note 98; SEC v. Hoover and Hoover Capital Management, Inc., supra note 97; SEC v. Evelyn Litwok & Dalia Eilat, supra note 97; SEC v. Ashbury Capital Partners, L.P., Ashbury Capital Management, L.L.C., and Mark Yagalla, supra note 97; SEC v. James S. Saltzman, supra note 95; In the Matter of Stephen V. Burns, Investment Advisers Act Release No. 1910 (Nov. 17, 2002); In the Matter of Michael T. Higgins, supra note 99; SEC v. David M. Mobley, Sr., et al., supra note 97; SEC v. Michael W. Berger, Manhattan Capital Management Inc., supra note 99; In the Matter of Charles K. Seavey and Alexander Lushtak, supra note 99; SEC v. Todd Hansen and Nicholas Lobue, supra note 235.

SEC v. Global Money Management, LP, LF Global Investments, LLC, and Marvin I. Friedman, supra note 102; SEC v. KS Advisors, Inc. et al., supra note 95; In the Matter of Alliance Capital Management, L.P., supra note 29; SEC v. Edward J. Strafaci, Litigation Release No. 18432 (Oct. 29, 2003); In the Matter of Stephen B. Markovitz, supra note 29; Michael Lauer, Lancer Management Group, LLC, and Lancer Management Group II, LLC, supra note 98; In the Matter of Martin W. Smith and World Securities, Inc., Investment Advisers Act Release No. 2124 (Apr. 18, 2003); SEC v. Platinum Investment Corp. et al., Litigation Release No. 17643 (July 31, 2002).

In the Matter of Alliance Capital Management, L.P., supra note 29; SEC v. Michael L. Smirlock, supra note 287; SEC v. Edward J. Strafaci, supra note 288; In the Matter of Nevis Capital Management, supra note 94; In the Matter of Martin W. Smith and World Securities, Inc., supra note 288; SEC v. Schwendiman Partners, LLC, Gary Schwendiman, and Todd G. Schwendiman, supra note 94; In the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, supra note 94; In the Matter of Zion Capital Management LLC, and Ricky A. Lang, supra note 101. Staff cannot estimate the amount of losses in 3 of these cases at this time.

Staff cannot estimate the amount of losses in 5 of these cases at this time.

As substantial inflows chase absolute returns, there may be pressure for hedge fund advisers to engage in strategies that may not be consistent with the funds' disclosure or may be unlawful. See David Reilly, Hot Hedge Fund Vega Grapples With Growth: Global/Macro Style of Investing May Provide Room to Maneuver, But a Door Is Closed to New Cash, The Wall St. J., June 4, 2004, at C1 (as hedge funds' assets explode, difficulties in finding winning strategies raises the specter of diminished returns and concentrations of investment risk that are difficult to unwind in a crisis); Mara Der Hovanesian, Will Hedge Funds Be Overrun By All The Traffic?, BusinessWeek, Mar. 11, 2002 (some hedge fund strategies are becoming less effective as the capacity of managers to generate high absolute returns diminishes when investment portfolios are too large). See also Alexander M. Ineichen, Absolute Returns (2003) at 47 (falling barriers to entry for new hedge fund advisers are causing a dilution of the talent pool, making adviser selection more difficult). In the absence of Commission oversight as a deterrent, these incentives may tempt hedge fund advisers to engage in fraud.

See, e.g., MFA Letter, supra note 51; LaRocco Letter, supra note 51; Chamber of Commerce Letter, supra note 52; ISDA Letter, supra note 52.

In addition, in two of the 43 cases against unregistered advisers, our examiners uncovered the fraud as a result of examining registered advisers who employed the principals of the hedge fund. See supra notes 94 and 95.

Cf. Alternative Investment Group Letter, supra note 47 (hedge fund managers will realize they are more likely to receive SEC scrutiny and will tighten their procedures toward a greater culture of compliance); Vantis August Letter, supra note 50 (possibility of SEC exams on short notice creates an extra incentive for firm professionals to remain disciplined and keep files updated on a timely basis). In addition, as discussed above, examination of regulatory issues relating to the deterrent effect of unannounced government inspections, under economic theories of monitoring and deterrence based on principal-agent models, suggest that randomized monitoring is sufficient to generate a deterrent effect. See supra note 88.

UnFarallon Letter, supra note 230; Comment Letter of Gregg D. Caplitz (Aug. 9, 2004) (“Caplitz Letter”); Comment Letter of Rosalind D. Herman (August 10, 2004) (“Rosalind Herman Letter”).

The difficulty many institutional investors have in obtaining information about hedge fund advisers is reflected in the Hennessee Group's survey clarifying the involvement of foundations and endowments in the hedge fund market. Among foundations and endowments responding to the survey, those supporting hedge fund adviser registration outnumbered its opponents by nearly 2 to 1. See Hennessee Foundation and Endowment Survey, supra note 39. Participants at our Hedge Fund Roundtable last year similarly spoke of the difficulty and costs that investors face in obtaining information from hedge fund advisers. Roundtable Transcript, May 15 (statement of Sandra Manzke) (“[I]t's very difficult to get answers out of managers, and they hold all the keys right now. If you want to get into a good fund, and you ask some difficult questions, you may not get that answer. Sure, there is a lot of access, to get online and do background checks, and hire firms * * *. But that's expensive. And can the retail investor do it? No. Firms like ours, we spend a lot of money, we have a lot more people working for us now to uncover these types of situations.”).

See, e.g., ICAA Letter, supra note 47, Alternative Investment Group Letter, supra note 47, Caplitz Letter, supra note 295.

Rule 206(4)-7.

Rule 206(4)-6.

Rule 204A-1.

Some registered hedge fund advisers used their own experiences to support this conclusion. See, e.g., Vantis August Letter, supra note 50, Alternative Investment Group Letter, supra note 47.

See supra note 29.

Id.

Id.

See, e.g., ICAA Letter, supra note 47; Rosalind Herman Letter, supra note 295; Patch Letter A, supra note 48; Comment Letter of Joe Allebaugh (July 14, 2004) (“Allebaugh Letter”); Vantis August Letter, supra note 50; Saul Letter, supra note 49.

See Section II.B.1 of this Release.

See, e.g., Ohio PERS Letter, supra note 47, ICAA Letter, supra note 47, ICI Letter, supra note 48, IMCA Letter, supra note 48.

See, e.g., MFA Letter, supra note 51, Tudor Letter, supra note 53.

See Section II.B.9 of this Release.

Many advisers to hedge funds are required to register with us because of other advisory business they have. Still others have chosen to register with us because their investor clients require it. Registered hedge fund advisers commented on the benefits of registration. See Vantis August Letter, supra note 50.

See Section VII.A.1.b. of the 2003 Staff Hedge Fund Report, supra note 18.

See, e.g., Saul Letter, supra note 49, Rosalind Herman Letter, supra note 295, Caplitz Letter, supra note 295.

See Section I.A. of this Release.

See, e.g., Vantis July Letter, supra note 106 (mandatory registration will improve the image of the hedge fund industry); Hennessee Foundation and Endowment Survey, supra note 39 (survey participant remark that registration “lends creditability to the field”); Comment Letter of North American Securities Administrators Association, Inc. (Oct. 18, 2004) (SEC registration will increase investor confidence, thereby benefiting hedge fund advisers).

See, e.g., MFA Letter, supra note 51, Chamber of Commerce Letter, supra note 52, ISDA Letter, supra note 52, David Thayer Letter, supra note 52.

Furthermore, section 208(a) of the Act [15 U.S.C. 80b-8(a)] expressly forbids registered advisers from implying that their services bear the imprimatur of the government. Section 208(b) of the Act permits a registered adviser to state that it is registered, but only if the effect of registration is not misrepresented.

Vantis August Letter, supra note 50, Alternative Investment Group Letter, supra note 47.

See Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management—Report of the President's Working Group on Financial Markets, supra note 43, at 2. The 2003 Staff Hedge Fund Report also noted that hedge funds' trading brings price information to our securities markets, thus improving market efficiency, and hedge funds also provide liquidity to our capital markets. See 2003 Staff Hedge Fund Report, supra note 18, at 4.

See, e.g., Madison Capital Letter, supra note 51; Chamber of Commerce Letter, supra note 52; ISDA Letter, supra note 52; Blanco Partners, supra note 52; Millrace Letter, supra note 92.

Vantis August Letter, supra note 50, Alternative Investment Group Letter, supra note 47, ICI Letter, supra note 48, ICAA Letter, supra note 47, CFA Institute Letter, supra note 47.

See Vantis August Letter, supra note 50, Alternative Investment Group Letter, supra note 47.

The MFA stated that one of its members expended $75,000 of internal staff time in preparing its Form ADV filing. See MFA Letter, supra note 51. MFA's comments are also not reflective of other feedback we have received on revised Form ADV and the IARD electronic filing system, which were launched in 2001. See Letter from Karen Barr, General Counsel, Investment Counsel Association of America, to Paul F. Roye, Director, Division of Investment Management, U.S. Securities and Exchange Commission (May 16, 2001) (noting that ICAA members found the filing system easy to use and found the form instructions and staff responses to frequently-asked questions to provide useful guidance).

In fact, our new rule makes only one small change to Part 1A, to better identify which advisers' pooled investment vehicles are hedge funds. See Section II.K. of this Release.

See rule 204-3, the brochure delivery rule.

Rule 204-2.

Rule 206(4)-2.

Rule 206(4)-6.

Rule 206(4)-7.

Rule 204A-1.

See, e.g., Schulte Roth Letter, supra note 51; ICAA Letter, supra note 47.

One private attorney commenting on the rule noted he knows of few hedge fund managers which do not already comply with the substantive provisions of the Advisers Act as a matter of best practice. Sidley Austin Letter, supra note 51.

Alternative Investment Group Letter, supra note 47; Vantis August Letter, supra note 50.

Our staff has estimated that between 690 and 1,260 hedge fund advisers would be new Advisers Act registrants under the new rule and rule amendments. See infra Section V of this Release; Section V of the Proposing Release. Aggregate start-up costs to establish required compliance infrastructure for all new registrants are therefore estimated to range from $31 to $57 million.

Schulte Roth Letter, supra note 51; Bryan Cave Letter, supra note 111; Davis Polk Letter, supra note 197.

Lander Letter, supra note 51, Madison Capital Letter, supra note 51, MFA Letter, supra note 51 (recounting the estimates of members, and noting larger firms' cost for a chief compliance officer can approach $500,000). Data from the SIA Report on Management and Professional Earnings in the Securities Industry 2003, modified by the SEC staff for an 1800-hour work-year and with a 35 percent markup for overhead, however, suggest that the total cost for hiring a full-time chief compliance officer in New York City would be approximately $234,000.

One law firm commented that it knew of few hedge fund advisers that are not already complying with the substantive provisions of the Advisers Act as a matter of best practices. Sidley Austin Letter, supra note 51. See also Superior Capital Letter, supra note 51 (noting that the Advisers Act compliance regulations would be “redundant” for this firm).

These underlying uncertainties surrounding these internal costs would introduce the same level of uncertainty to various alternatives that we might pursue in determining these costs. For example, advisory firms themselves are not likely to be able to provide reliable estimates for several reasons. First, experiences will vary across firms; second, few firms are likely to have allocated the internal resources necessary to assess which costs are a direct result of legal requirements and which arise from other factors; and third, firms' experience with some newer requirements (such as the adviser compliance rule and the adviser code of ethics rule) is still limited. Attempting to estimate the number of staff hours involved (and applying industry standard wage and benefit costs for the corresponding types of personnel) would entail the same uncertainties.

Comment Letter of Joseph L. Vidich (Aug. 7, 2004) (“Vidich Letter”) (currently managing $10 million hedge fund); Comment Letter of Venkat Swarna (Sept. 14, 2004) (“Swarna Letter”) (anticipates managing $2 million hedge fund). Although these commenters would not be covered by our registration requirement, we have taken their cost estimates into consideration, because other small firms that will be covered did not provide us with quantified estimates.

See Vidich Letter, supra note 338; Superior Capital Letter, supra note 51; LaRocco Letter, supra note 51; see also ISDA Letter, supra note 52.

See, e.g., Millrace Letter, supra note 92; see also Seward & Kissel Letter, supra note 111; Blanco Partners Letter, supra note 52.

ICAA Letter, supra note 47, CFA Institute Letter, supra note 47.

Some commenters suggested the threshold for hedge fund adviser registration should be $50 million, to address their concerns that the cost burden of adviser registration might be disproportionate for advisers managing lesser amounts of assets. See, e.g., LaRocco Letter, supra note 51. However, many currently-registered firms, which presently comply with these same registration obligations, manage less than $50 million. As of September 30, 2004, 2,758 advisers registered with us reported that they were managing less than $50 million in client assets. These advisers represent 32 percent of our registrant pool. We also note that establishing a higher assets under management registration threshold for advisers to private funds would allow these other advisers to avoid registration merely by pooling some of their clients' assets into a private fund.

In addition to asset-based investment management fees that are comparable to advisory fees charged by non-hedge fund advisory firms, hedge fund advisers also typically earn incentive compensation equaling 20 percent of the fund's net investment income. See supra note 11.

MFA Letter, supra note 51 (reporting experience of one registered hedge fund adviser).

As we discuss elsewhere, the absence of a comprehensive database of hedge fund advisers makes it difficult to estimate the number or size of hedge fund advisory firms that will be affected by the new rule. However, staff estimates half or more of the larger hedge fund advisers are likely already registered with us. See also The Hedge Fund 100, supra note 70 (estimating that even the top 100 hedge fund advisers manage in the range of $2 billion to $11.5 billion).

Sidley Austin Letter, supra note 51.

Vantis August Letter, supra note 50 (review provides additional assurance that any deficiencies not already identified by internal or external audit are identified; exam staff offers helpful instruction in regulatory issues and assistance in developing policies and procedures).

See, e.g., Schulte Roth Letter, supra note 51, Davis Polk Letter, supra note 197, Rodney Pitts Letter, supra note 52, Sheila Bair Letter, supra note 89, Comment Letter of Alex Cook (Aug. 26, 2004) (“Alex Cook Letter), Tudor Investment Letter, supra note 53.

Rule 206(4)-7. See Compliance Programs of Investment Companies and Investment Advisers, supra note 109.

See Section V. of the Proposing Release.

Staff estimated that between 690 and 1,260 hedge fund advisers will be new Advisers Act registrants under the new rule and rule amendments. See Section V. of the Proposing Release.

See Section V. of the Proposing Release.

975 filings of the complete form at 22.25 hours each, plus 975 amendments at 0.75 hours each, plus 6.7 hours for each of the 975 hedge fund advisers to deliver copies of their codes of ethics to 10 percent of their 670 clients annually who request it, at 0.1 hours per response. (975 × 22.25) + (975 × 0.75) + (975 × (670 × 0.1) × 0.1).

156 filings (975 × 0.16), consisting of 78 full withdrawals at 0.75 hours each and 78 partial withdrawals at 0.25 hours each.

We expect that no hedge fund advisers would be small advisers that would be eligible to file for a continuing hardship exemption.

1 filing (975 × 0.001) at 1 hour each.

2 filings (975 × 0.002) at 1 hour each.

See section 210(b) of the Advisers Act [15 U.S.C. 80b-10(b)].

See rule 204-2(e).

975 hedge fund advisers x 191.78 hours per adviser = 186,985.5 hours.

975 hedge fund advisers times 694 hours per adviser.

975 hedge fund advisers at 117.95 hours per adviser annually.

975 hedge fund advisers times 670 clients times 0.5 hours per annual financial statement distribution.

195 respondents (975 × 0.2) at 7.04 hours annually per respondent.

169 respondents (975 × 0.173) at 7.5 hours annually per respondent.

We estimate that 975 hedge fund advisers will spend 10 hours each annually documenting their voting policies and procedures, and will provide copies of those policies and procedures to 10 percent of their 670 clients annually at 0.1 hours per response.

975 hedge fund advisers at 80 hours per adviser annually.

15 U.S.C. 80b-2(c).

Rule 0-7(a) [17 CFR 275.0-7(a)].

15 U.S.C. 80b-3A.

5 U.S.C. 603(a).

Rule 206(4)-2.

Rule 206(4)-2(b)(3).

We initially proposed to extend the period for all investment advisers. Commenters pointed out that such extension would leave the advisers to funds of funds in the same situation, i.e., the underlying hedge funds would use the entire 180-day period, and the advisers to the funds of funds would have no time to prepare financial statements for the funds of funds after they receive the financial statements from underlying hedge funds.

This estimate is based on the information provided by SEC-registered advisers in Form ADV, Part 1A.

See Section VIII.A. of this Release for the definition of a small entity. Unlike the other rules and amendments the Commission is proposing today, the scope of the amendment to rule 206(4)-2 is not limited to hedge fund advisers that would be subject to registration requirements under rule 203(b)(3)-2.

15 U.S.C. 77s(a).

15 U.S.C. 78w(a) and 78bb(e)(2).

15 U.S.C. 77sss(a).

15 U.S.C. 80a-37(a).

15 U.S.C. 80b-2(a)(17), 80b-3, 80b-4, 80b-6(4) and 80b-11(a).

Section 211(a) also provides that “the Commission shall have authority from time to time to make, issue, amend, and rescind such rules and regulations and such orders as are necessary or appropriate to the exercise of the functions and powers conferred upon the Commission * * *.”

§ 275.203(b)(3)-1

Definition of “client” of an investment adviser.

§ 275.203(b)(3)-2

Methods for counting clients in certain private funds.

§ 275.203A-3

Definitions.

§ 275.204-2

Books and records to be maintained by investment advisers.

§ 275.205-3

Exemption from the compensation prohibition of section 205(a)(1) for investment advisers.

§ 275.206(4)-2

Custody of funds or securities of clients by investment advisers.

§ 275.222-2

Definition of “client” for purposes of the national de minimis standard.

Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2266 (July 20, 2004) [69 FR 45172 (July 28, 2004)] (“Proposing Release”).

In addition to the many comments the Commission received, the diversity of voices is illustrated by the appearance of editorials opposing the rulemaking in the New York Times, Wall Street Journal, and Washington Post. See Hands off Hedge Funds, Wash. Post, B6, July 18, 2004; Reforming Hedge Funds, N.Y. Times, D12, June 27, 2004; The SEC's Expanding Empire, Wall St. J., A14, July 13, 2004.

Registration Under the Advisers Act of Certain Hedge Fund Advisers, Investment Advisers Act Release No. 2333 ( Dec. 2, 2004) (“Adopting Release”).

See Robert Schmidt, Hedge Fund Rule May Cause SEC to Drop Smaller Firms, Roye Says, Bloomberg (Oct. 28, 2004).

Such a major shift in the Commission's regulatory approach warranted a significantly longer comment and comment review period than we afforded it. The proposal appeared in the Federal Register on July 28, 2004, and comments were due by September 15, 2004. Concerned about the brevity of the comment period and its inopportune timing during the vacation month of August, ten commenters requested a reasonable extension, but no extension was granted.

Moreover, once the comment period closed, the staff did not prepare a formal summary analyzing the issues raised by the more than 160 comment letters, most of which opposed the rule. Such summaries are standard procedure for rulemakings of this significance, because the summaries help ensure that the comments are considered by the commissioners and staff. The abbreviated discussion of the comment letters in the adopting release is not a sufficient substitute for a comment summary that is prepared before drafting the release to assist the Commission in deciding whether to adopt a proposed rulemaking and, if so, whether to make any changes.

The majority seems to have concluded that it had already heard all perspectives at the Commission's roundtable on hedge funds in May of 2003 and through the subsequent staff study. See Securities and Exchange Commission, Hedge Fund Roundtable (May 14-15, 2003) (transcript and webcast available at: http://www.sec.gov/spotlight/hedgefunds.htm ) (“Roundtable”); 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 ) (“2003 Staff Hedge Fund Report”). However, the roundtable and staff study disproved the existence of the problems that some thought might be found in the hedge fund industry. Consequently, the public did not have sufficient notice that a rulemaking would be forthcoming, much less of the specifics of the proposed rulemaking.

The Commodity Futures Trading Commission (“CFTC”), for example, has offered to enter into an information-sharing arrangement with the Commission and other relevant agencies. See Comment Letter of the CFTC (Oct. 22, 2004). The National Futures Association, which is a self-regulatory organization for the futures industry, likewise offered to share the information that it collects about hedge funds. See Comment Letter of the National Futures Association (Sept. 14, 2004).

Financial Crimes Enforcement Network; Anti-Money Laundering Programs for Investment Advisers, 68 FR 23646 (May 5, 2003). The proposed rule would apply to, among others, any adviser that has at least $30 million in assets under management and is exempt from registration under section 203(b)(3) of the Investment Advisers Act [15 U.S.C. 80b-3(b)(3)], unless it is otherwise required to have an anti-money laundering program and is subject to examination by a federal regulator. See section 103.50(a)(2) of the proposed rule. [31 CFR 103.50(a)(2)]. As proposed, the form is intended to identify unregistered advisers, but the Commission could work with the Department of Treasury to tailor the form to elicit the information that the Commission determines that it needs.

The President's Working Group is made up the heads of the Treasury, the Federal Reserve Board, the CFTC, and the SEC.

See Letter from Congressman Richard H. Baker to John Snow, Chairman of the President's Working Group on Financial Markets (Oct. 7, 2004). Oddly, the majority cites this letter, the existence of which we learned about the day before the Open Meeting for this rulemaking, in support of the proposition that “During and after the comment period, our staff has continued to have discussions with other regulators relating to hedge fund adviser regulation.” Adopting Release at n. 55.

See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, Testimony before the Senate Banking, Housing and Urban Affairs Committee (July 20, 2004) (“My problem with the SEC's current initiative is that the initiative cannot accomplish what it seeks to accomplish. Fraud and market manipulation will be very difficult to detect from the information provided by registration under the 1940 Act.”); Comment Letter of the CFTC (Oct. 22, 2004) (requesting exemption for CFTC-registered advisers that “would be complemented by a formal information sharing agreement between the CFTC and SEC related to CFTC-registered CPOs and CTAs”); Judith Burns, Split SEC Set to Vote on Tighter Hedge Fund Oversight, Dow Jones News Service, Oct. 25, 2004 (“Federal Reserve Chairman Alan Greenspan and Treasury Secretary John Snow worry that more regulation won't prevent fraud and could reduce benefits that hedge funds bring to markets.”).

Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management—Report of the President's Working Group on Financial Markets, at B-16 (Apr. 1999) (available at: http://www.treas.gov/press/releases/reports/hedgfund.pdf ) (the Council of Economic Advisers, the Federal Deposit Insurance Corporation, the National Economic Council, the Federal Reserve Bank of New York, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision also participated in the study and supported its conclusions and recommendations). The majority contends that the report did not focus on issues relevant to the Commission's administration of the Advisers Act, but rather on “the stability of financial markets and the exposure of banks and other financial institutions to the counterparty risks of dealing with highly leveraged entities.” Adopting Release at n. 43. The Commission cannot protect the nation's securities markets without considering the effect of its rules on the stability of the financial markets.

See Alan Greenspan, Chairman, Federal Reserve Board, Written Responses to Questions from Chairman Shelby in Connection with Testimony before the Senate Banking, Housing and Urban Affairs Committee, at 3 (July 20, 2004).

Adopting Release at n. 43.

As the Commission has explained elsewhere, the Commission's interest in a particular area does not preclude its working with other regulators. See, e.g., SEC, 2002 Annual Report 1 (available at: http://www.sec.gov/pdf/annrep02/ar02fm.pdf ) (“Though it is the primary overseer and regulator of the U.S. securities markets, the SEC works closely with many other institutions * * *”). The Adopting Release notes that the staff met with staff of various fellow regulators, but because these meetings were not documented in the comment file, it is difficult to discern what occurred at those meetings. See Adopting Release at n. 17.

See Comment Letter of the CFTC (Oct. 22, 2004) (“in the interest of good government and in order to avoid duplicative regulation, the CFTC respectfully requests that the SEC provide a registration exemption for these CFTC registrants that do not hold themselves out to the general public as investment advisers.”). Many other commenters also recommended an exemption for CFTC-registered entities. The majority dismisses requests to exempt CFTC-registered commodity pool operators by arguing that Congress already addressed this concern by adding section 203(b)(6) to the Advisers Act in 2000 [15 U.S.C. 80b-3(b)(6)], but that section covers only commodity trading advisers, not commodity pool operators. See Adopting Release at text accompanying n. 128. We share the majority's hope that the staff will consult with the CFTC staff regarding examinations, but staff discussions at the implementation stage cannot substitute for discussions about the Commission's proposal prior to adoption. See Adopting Release at n. 130.

Many commenters recommended that the Commission should not require the registration of certain advisers that are subject to oversight by foreign authorities. See, e.g., Comment Letter of the European Commission (Sept. 15, 2004); Comment Letter of the Fédération Européenne des Fonds et Sociétés d'Investissement (Sept. 15, 2004); Comment Letter of the Financial Services Roundtable (Sept. 15, 2004); the International Bar Association (Sept. 14, 2004).

See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, Written Responses to Questions from Chairman Shelby in Connection with Testimony before the Senate Banking, Housing and Urban Affairs Committee, (July 20, 2004) (“If there was a public policy reason to monitor hedge fund activity, the best method of doing so without raising liquidity concerns would be indirectly through oversight of those broker-dealers (so-called prime brokers) that clear, settle, and finance trades for hedge funds. Although the use of multiple prime brokers by the largest funds would complicate the monitoring of individual funds by this method, such monitoring could provide much useful information on the hedge funds sector as a whole.”).

See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, Written Responses to Questions from Chairman Shelby in Connection with Testimony before the Senate Banking, Housing and Urban Affairs Committee (July 20, 2004) (“Concerns about market manipulation, whether by hedge funds or others, can best be addressed by enhanced market surveillance.”).

15 U.S.C. 80a-3(c)(1) and 15 U.S.C. 80a-3(c)(7).

17 CFR 275.203(b)(3)-1.

A number of commenters suggested this approach or a similar annual census form for hedge fund advisers. See, e.g., Comment Letter of the American Bar Association, Section of Business Law (Sept. 28, 2004); Comment Letter of Sheila C. Bair, Professor of Financial Regulatory Policy, University of Massachusetts—Amherst (Sept. 15, 2004); Comment Letter of the U.S. Chamber of Commerce (Sept. 15, 2004); Comment Letter of Kynikos Associates (Sept. 15, 2004); Comment Letter of the Managed Funds Association (Sept. 15, 2004); Comment Letter of Seward & Kissell LLP (Sept. 15, 2004); Comment Letter of Schulte Roth & Zabel, LLP (Sept. 15, 2004); Comment Letter of Tudor Investment Corp. (Sept. 15, 2004). Other commenters suggested requiring hedge fund advisers to file audited financial statements. See, e.g., Comment Letter of Madison Capital Management LLC (Sept. 15, 2004); Comment Letter of James E. Mitchell (Sept. 1, 2004); Comment Letter of Joseph L. Vidich (Aug. 7, 2004); Comment Letter of Willkie, Farr & Gallagher (Sept. 13, 2004) (recommending self-executing exemptive application procedure for advisers that provide investors with audited financials and valuation disclosures).

See Adopting Release at n. 150.

See Adopting Release at text accompanying n. 154. The majority also concluded that it was not worthwhile for the staff to try to make use of the information generated by existing transactional reporting requirements. See Adopting Release at text following n. 155. This seems to be a premature conclusion, particularly in light of commenters' suggestion to tailor current forms so that they meet the Commission's information needs. See, e.g., Comment Letter of Bryan Cave LLP (Aug. 16, 2004) (recommending extensive amendments to Regulation D and Form D and Suspicious Activity Reports); Comment Letter of Madison Capital Management LLC (Sept. 15, 2004); Comment Letter of Proskauer Rose LLP (Aug. 31, 2004); Comment Letter of Tudor Investment Corp. (Sept. 15, 2004).

The majority estimates the hedge fund industry to be $870 billion, which is dwarfed by the approximately $23 trillion under management by registered advisers. See Adopting Release at text accompanying n. 19 and following n. 71.

Marcia Vickers, The Most Powerful Trader on Wall Street You've Never Heard of, BusinessWeek, July 21, 2003, at 66.

See Henny Sender, Hedge Funds Skid on Convertible Bonds, Wall St. J., June 30, 2004, at C4 (hedge funds account for about 95% of all trading in convertible bonds).

See, e.g., Comment Letter of Amaranth Advisors LLC (Sept. 15, 2004) (hedge fund adviser explains that it does not operate in the shadows, but under the scrutiny of a number of regulators); Comment Letter of the Greenwich Roundtable (Sept. 15, 2004) (“The hedge fund industry is already a highly legitimate and professional industry. Sophisticated investors in the hedge fund community make significant allocation decisions based in large part on the rigorous due diligence examinations that they personally perform prior to making an investment.”); Comment Letter of the Managed Funds Association (Sept. 15, 2004) (detailing regulatory obligations to which hedge fund advisers are subject). The perception that hedge funds operate in the shadows might be attributable partially to the limitations to which hedge fund advisers are subject. See, e.g., Testimony of Michael Neus, Principal and Chief General Counsel, Andor Capital Management, LLC, at the Hedge Fund Roundtable, supra n. 5 (May 14, 2004) (“it's a highly professional, highly organized industry which, because of restrictions on advertising or holding yourself out to the public, we are not capable of sharing with the general public * * *”).

See 2003 Staff Hedge Fund Report, supra n. 5, at 73. The majority notes that it is “not alone in [its] concerns regarding hedge fund frauds” and cites the results of interviews with managers of European financial institutions about the state of the European Financial Market. See Adopting Release at n. 27 (citing Bank of New York, Restoring Broken Trust: A Pan European Study of the Causes of Declining Trust in the European Financial Services Industry and Analysis of the Actions Needed to Rebuild Investor Trust (July 2004). While interesting, the opinions expressed by these European managers are largely immaterial in the context of the U.S. industry, and it is not clear how today's rulemaking will address these concerns.

See Testimony of Patrick J. McCarty, General Counsel of the CFTC, before the U.S. Senate Committee on Banking, Housing and Urban Affairs 1 (July 15, 2004). See also Comment Letter of the National Futures Association (Sept. 14, 2004) (NFA's experience with the hedge funds it oversees is “consistent with the comparatively small number of CFTC and SEC enforcement actions involving commodity pool and hedge fund activities.”).

Hedge fund advisers, like other advisers, generally will be required to register only if they have assets under management of $30 million or more and advisers with between $25 million and $30 million will be permitted to register. See Investment Advisers Act section 203A(a)(1) [15 U.S. 80b-3a(a)(1)] and rule 203A-1 [17 CFR 275.203A-1] thereunder.

The majority states that “[o]ur examination staff uncovered, during routine or sweep exams, five of the eight cases we brought against registered hedge fund advisers * * *.” Adopting Release at n. 94 and accompanying text. One of those cases was uncovered during a sweep examination that was prompted by a civil complaint filed by the New York Attorney General. See In the Matter of Alliance Capital Management, L.P., Investment Advisers Act Release No. 2205 (Dec. 18, 2003). In another, the problem was not discovered until seven years after it began. See In the Matter of Portfolio Advisory Services, LLC and Cedd L. Moses, Investment Advisers Act Release No. 2038 (June 20, 2002). The Commission cannot rely on registration to unearth violations in a prompt and predictable manner.

In our dissent to the Proposing Release, we discussed these 46 cases in detail. See Proposing Release, supra n. 1, at 45197-98. The advisers implicated in the five newly-identified cases likely would fall outside the scope of the rulemaking. See SEC v. Haligiannis, et al, Litigation Release No. 18853 (Aug. 25, 2004) (having raised $27 million over eight years, the hedge fund's president and general partners likely would not have been required to register); SEC v. Scott B. Kaye, et al., Litigation Release No. 18845 (Aug. 24, 2004) (having raised only $1.9 million, the adviser likely would not have been required to register); SEC v. Gary M. Kornman, Litigation Release No. 18836 (Aug. 18, 2004) (individual that used inside information to make trades on behalf of hedge funds was owner of broker-dealer registered with the Commission); SEC v. Anthony P. Postiglione, Jr., et al., Litigation Release No. 18824 (Aug. 9, 2004) (having raised approximately $5 million, the adviser likely would not have been required to register); SEC v. Adam G. Kruger and Kruger, Miller, and Tummillo, Inc., Investment Advisers Act Release No. 2297 (Sept. 15, 2004) (having raised approximately $1 million, the adviser likely would not have been required to register).

The majority anticipates that hedge fund investors will demand that even new hedge fund advisers register. These advisers will be able to register even before they have $25 million under management if they have a reasonable expectation of meeting the $25 million threshold within 120 days. See rule 203A-2(d) [17 CFR 275.203A-2(d)]. It is not realistic to assume that all new advisers would register. Reaching $25 million in assets under management within four months is likely to be an unrealistic goal for many.

See also SEC v. Sanjay Saxena, Litigation Release No. 16641 (Aug. 2, 2000) (having already been barred by the Commission from acting as an investment adviser, the defendant used his wife as a front for his advisory activity).

An additional 51 funds of hedge funds are registered with the Commission as investment companies but can be sold only through private offerings. The Commission does not have data on the number of additional funds of hedge funds that exist but are not registered with the Commission.

Bernstein 2003 Report, supra note 24, at 18.

Chairman William H. Donaldson, Remarks at Open Meeting: Registration of Hedge Fund Advisers (Oct. 26, 2004).

See Comment Letter of W. Hardy Callcott, Bingham McCutchen LLP (Sept. 15, 2004) (“The Commission should not rely on a risk assessment model to replace regular cycle examinations—certainly not until such a model has been rigorously tested and has a track record of effective implementation.”).

As Chairman Greenspan noted: Even should SEC's proposed risk evaluation surveillance of hedge funds detect possible trading irregularities, which I doubt frankly, those irregularities will likely be idiosyncratic and of mainly historic interest, because by the time of detection, hedge funds would have long since moved on to different strategies.

Alan Greenspan, Chairman, Federal Reserve Board, Testimony before the Senate Banking, Housing and Urban Affairs Committee (July 20, 2004).

See Adopting Release at text accompanying nn. 87-88. Because examinations take place so infrequently, the marginal increase in the chance of getting caught will not change the fraudster's calculus significantly. Further, the majority, to be consistent in its deterrence analysis, should take into account the shift of resources away from other types of advisers and hence the resulting decrease in deterrence for those advisers, particularly because they see the Commission's focus on hedge fund advisers as an area of emerging risk.

As Chairman Donaldson noted when testifying before Congress this year, the Commission has only 495 staff conducting examinations of approximately 8,000 mutual funds, managed in over 900 fund complexes, as well as more than 8,000 investment advisers. See Testimony of William H. Donaldson, Chairman, Securities and Exchange Commission, before the House Subcommittee on Commerce, Justice, State, and the Judiciary, Committee on Appropriations (Mar. 31, 2004) (“During most of the period from 1998 to early 2003, the SEC's examination program for funds and advisers had approximately 370 members on its staff (including examiners, supervisors, and support staff). Routine examinations were conducted every five years. In the last two years, program staffing was increased by one-third, to approximately 495 employees. With this staffing increase, the SEC has increased the frequency of examinations of funds and advisers posing the greatest compliance risks, and is conducting more examinations targeted to areas of emerging compliance risk.”).

Testimony of William H. Donaldson, Chairman, SEC, before the Senate Committee on Banking, Housing and Urban Affairs (July 15, 2004) (“I have asked the staff to develop an enhanced risk-based approach to oversight and examination of our investment adviser registrants, including hedge fund advisers.”).

Periodic examinations would likely have no deterrent effect on scam artists, who, under the guise of operating a hedge fund set out to steal money from unwitting investors, because these types of individuals will simply not register.

2003 Staff Hedge Fund Report, supra n. 5, at 80 (“To date, however, the staff has not uncovered evidence of significant numbers of retail investors in hedge funds.”).

See, e.g., Testimony of Robert Schulman, Chairman and CEO, Tremont Asset Management, at the Roundtable, supra n. 5 (May 14, 2004) (“It is not a massive flow of money from retail or high net worth investors using registered products. That's not what's fueled the growth here to date. It may come to be that, but that's not what it's been today.”).

See, e.g., Comment Letter of the Managed Fund Association (Sept. 15, 2004) (noting the validity of the Commission's concern about the increased number of persons qualifying as individual investors and recommending an adjustment of the accredited investor standard); Comment Letter of Porter, Felleman, Inc. (Aug. 16, 2004); Comment Letter of Tudor Investment Corp. (Sept. 15, 2004). And if, as the majority notes, hedge fund inflows already are so rapid that hedge fund advisers have more to invest than they can handle, then they will not need to look to retail investors. See Adopting Release at n. 21 and accompanying text.

See Greenwich Associates, Press Release, Alternative Investments May Disappoint Dabblers (Jan. 21, 2004) (available at: http://www.greenwich.com ).

This assumes that $72 billion of pension money is invested in hedge funds, which are estimated to have total assets of $870 billion. See Adopting Release at n. 38 and text accompanying n. 19. The majority does not tell us what proportion of pension fund investments are invested in hedge funds without registered advisers.

See Hewitt Investment Group, In Brief: Immunization—Theory and Practice 5 (July 2004) (available at: http://www.hewittinvest.com/pdf/InBrief_Immunization.pdf ) (citing Greenwich Associates Market Characteristics 2003 Report) (based on asset allocation of private pension funds). See also Comment Letter of the National Venture Capital Association (Sept. 15, 2004) (noting that pension funds, foundations and university endowments have long invested in venture capital funds).

The Department of Labor oversees the conduct of private pension plan advisers. In the public pension fund context, state law requires that the pension fund adviser, often an elected official, act for the benefit of the pensioners.

See, e.g., Transcript of Chronicle of Higher Education Colloquy with John S. Griswold of the Commonfund Group, (May 27, 2004) (available at: http://chronicle.com/colloquylive/2004/05/endowments/ ) (noting the role alternative investments, including hedge funds, play in diversifying endowment portfolios, reducing portfolio risk, and boosting returns).

See, e.g., MFA Letter, supra note 51; Comment Letter of Chamber of Commerce of the United States of America (Sept. 15, 2004) (“Chamber of Commerce Letter”); Comment Letter of International Swaps and Derivatives Association (Sept. 15, 2004) (“ISDA Letter”); Comment Letter of David Patch (Sept. 10, 2004) (“Patch Letter B”); Comment Letter of Rodney Pitts (Sept. 15, 2004) (“Rodney Pitts Letter”); Comment Letter of Blanco Partners LP (Sept. 13, 2004) (“Blanco Partners Letter”); Comment Letter of Mark Acquino (Aug. 8, 2004)(“Acquino Letter”).

See, e.g., Comment Letter of Leon M. Metzger (Sept. 15, 2004).

See supra n. 1. Another option discussed in the Adopting Release is asking Congress for more funding, a request Congress might be loathe to fulfill absent assurances the new funds would not again be applied to expand our regulatory reach. See Adopting Release at Section V.

Although both the Proposing and Adopting Releases mentioned raising the threshold for registration “to a slightly higher amount” as a possible way of compensating for the increase in registered advisers resulting from the rulemaking, the Proposing Release did not solicit comment on whether this was an appropriate reallocation of resources. See Proposing Release, supra n. 1, at section V and Adopting Release at section V.

S.R. 104-293, at 10 (June 26, 1996).

See, e.g., Comment Letter of the Greenwich Roundtable (Sept. 15, 2004) (nonprofit organization made up of private and institutional investors opposed the rulemaking), Comment Letter of Rodney C. Pitts (Sept. 15, 2004) (hedge fund investor suggesting that Commission resources should not be diverted to protect the relatively small number of hedge fund investors), Comment Letter of Myra Tatum, Pointer Management Co. (Aug. 26, 2004) (manager of fund of funds noting that mandatory registration will not benefit investors; fund of funds manager already conducts extensive due diligence and ongoing monitoring of hedge fund managers). The majority cites a survey conducted by the Hennessee Group in support of its rulemaking. See Hennessee Group, 2004 Hennessee Hedge Fund Survey of Foundations and Endowments (submitted as a comment letter for this rulemaking). While 59 percent of the 46 respondents supported the rulemaking, foundations and endowments opposing the rulemaking were larger, more heavily invested in hedge funds, and had more years of experience in hedge fund investment than entities that favored the rulemaking. See id.

As one commenter pointed out, “the “institutionalization” of the hedge fund market has had many salutary effects on the industry [because] [m]ost such institutions require funds to complete voluminous questionnaires about management, investment procedures, and operational and risk controls.” Comment Letter of Schulte, Roth & Zabel LLP (Sept. 15, 2004). Moreover, reports by auditors are a commonly-used method of demonstrating the integrity of internal controls. See, e.g., Codification of Accounting Standards and Procedures, Statement on Auditing Standards No. 70, Service Organizations. See also Comment Letter of Blanco Partners LP (Sept. 13, 2004) (“We feel that having the highest quality attorneys, auditors and prime[] brokers is a selling point for our fund.”). In other contexts, the Commission views favorably the use of outside control reports. See, e.g., Fair Administration and Governance of Self-Regulatory Organizations; Disclosure and Regulatory Reporting by Self-Regulatory Organizations; Recordkeeping Requirements for Self-Regulatory Organizations; Ownership and Voting Limitations for Members of Self-Regulatory Organizations; Ownership Reporting Requirements for Members of Self-Regulatory Organizations; Listing and Trading of Affiliated Securities by a Self-Regulatory Organization, Securities Exchange Act Release No. 50699 (Nov. 18, 2004).

See, e.g., Comment Letter of Sheila C. Bair, Dean's Professor of Financial Regulatory Policy, University of Massachusetts-Amherst (Sept. 15, 2004) (“By promising a ‘culture of compliance’ through registration, the SEC may be encouraging investors to take a ‘free ride’, reducing the amount of due diligence they would otherwise conduct on their own. The first line of defense for sophisticated investors should be their own due diligence, not SEC compliance measures, which are already seriously strained.”); Comment Letter of W. Hardy Callcott, Bingham McCutchen LLP (Sept. 15, 2004) (“When not promised that the SEC will oversee the adviser, hedge fund investors have been able through private ordering to negotiate adequate protections for themselves—protections apparently at least as effective as those provided by SEC registration and oversight.”), Comment Letter of the U.S. Chamber of Commerce (“[C]ounterparty surveillance (e.g., extended pre-investment due diligence by investors and discipline imposed by lenders) is today pervasive among institutions and other sophisticated [private investment fund] investors.”); Comment Letter of Price Meadows Inc. (Sept. 15, 2004) (noting that market pressures are enhancing investor protection as reflected in the increasing percentage of hedge funds that are audited or rely on third-party administration).

See, e.g., Adopting Release at text accompanying n. 61 (“But commenters have not persuaded us that requiring hedge fund advisers to register under the Act, requiring them to develop a compliance infrastructure, or subjecting them to our examination authority will impose undue burdens on them or interfere significantly with their operations.”). The majority bolstered the cost-benefit analysis and the discussion of alternatives in the final release three weeks after the vote to approve the rulemaking. Such issues should have been thoroughly explored prior to the vote.

Compare Adopting Release at n. 64 and accompanying text (relying on the “persuasive testimonials” of two commenters who did not provide empirical data to conclude that registration is not overly burdensome) with Adopting Release at text following n. 70 (“The bare assertions of adverse consequences of registration under the Advisers Act offered by many commenters opposed to our proposed rule, and the anecdotal evidence offered by others, simply do not stand up to scrutiny.”).

See, e.g., Adopting Release at nn. 344-46 and accompanying text.

In fact, the only cost estimates offered by the majority in its cost-benefit analysis are per-firm costs of $20,000 for professional fees and $25,000 for internal costs that firms would incur in establishing the required compliance infrastructure and aggregate costs of $31 to $57 million. See Adopting Release at n. 333 and accompanying text.

See Vantis August Letter, supra note 50 (“While there are incremental costs associated with registration [under the Advisers Act], the burdens are not excessive for any serious investment firm, which is committed to timely and accurate reporting.”) and Alternative Investment Group Letter, supra note 47 (“We believe that the compliance costs will be minimal to the well-managed advisor.”).

The antifraud prohibitions of section 206 [15 U.S.C. 80b-6], including provisions restricting an adviser's ability to engage in principal trades and agency cross-transactions with clients, apply to any investment adviser that makes use of the mails or any means of interstate commerce. In contrast, section 204 [15 U.S.C. 80b-4] (authorizing the Commission to require advisers to issue reports and maintain books and records) applies to all advisers other than those specifically exempted from registration by section 203(b) of the Act. Thus, although unregistered advisers are subject to the antifraud provisions of the Act, our ability to enforce those provisions is hampered because in the absence of a registration requirement we cannot identify and examine these advisers.

In the past, hedge fund industry participants cited the restrictions on registered advisers charging performance-based compensation in section 205(a)(1) of the Act [15 U.S.C. 80b-5(a)(1)] as being incompatible with the operation of hedge funds. See Hard Times Come to the Hedge Funds, supra note 13; Lawrence J. Berkowitz, Regulation of Hedge Funds, 2 Rev. of Securities Reg. (1969). In 1998, however, the Commission eliminated this concern by adopting amendments to rule 205-3. Exemption to Allow Investment Advisers to Charge Fees Based Upon a Share of Capital Gains Upon or Capital Appreciation of a Client's Account, Investment Advisers Act Release No. 1731 (July 15, 1998) [63 FR 39022 (July 21, 1998)]. Further, we proposed to grandfather hedge fund advisers' existing investors that would otherwise not qualify to pay performance fees. See Section II.G. of the Proposing Release. No hedge fund industry participant with whom our staff spoke during their year-long investigation indicated that section 205 or the qualified client criteria in rule 205-3 would present any concerns to hedge funds.

See, e.g., Comment Letters of Blanco Partners LP (Sept. 13, 2004) (small advisers will be disproportionately burdened); Venkat Swarna (Sept. 14, 2004) (“We estimate the annual compliance costs of a state or federal registration to be in the range of 20,000 to 25,000. These compliance costs would be prohibitive to a small advisor like ours, as these costs alone constitute a sizeable percentage of the portfolio of the fund we would be managing in our case more than 1[%]”); Joseph L. Vidich (Aug. 7, 2004) (“In a one or two person firm, with 10 million under management, the annual cost of compliance could easily fall between 25,000 and 50,000, which represents twenty five to fifty percent of the firms asset management fee.”). See also Hedge Fund Regulation May Force Consolidation, PipeLine 3 (June 15, 2003) (reporting study findings that registration would impose significant burdens on small hedge funds in the range of $50,000 to $100,000 annually) (citing Sanford C. Bernstein & Co., The Hedge Fund Industry—Products, Services, or Capabilities? (May 19, 2003); Arden Dale, Small Mutual-Fund Firms Cry Uncle—New Rules Protect Investors, but They Can be a Burden; Cost of a Compliance Cop, Wall St. J., C15, Sept. 13, 2004 (reporting difficulty of mutual fund advisers that have less than a few billion dollars under management to bear the costs of regulatory requirements, including the Commission's compliance requirement).

See, e.g., Comment Letter of Blanco Partners LP (Sept. 13, 2004) (contending that registration will burden small hedge fund advisers more heavily than the average small adviser); Comment Letters of the International Swaps and Derivatives Association (Sept. 15, 2004) and Guy Judkowski, Hedgehog Capital (explaining that, in contrast to many other small advisers, some small hedge fund advisers deliberately remain small in order to effectively pursue a particular strategy).

Even proponents of registration acknowledge that its costs will be significant enough to deter some advisers from entering the business. See, e.g., Ron Orol, Regulation? Bring it on, TheDeal.com, Oct. 11, 2004 (interview of Steven Holzman, the managing partner of Vantis Capital Management LLC, who wrote two comment letters cited repeatedly in support of registration) (Mr. Holzman predicted that registration would help his business by raising barriers to entry and anticipated that “[w]ith registration, we will have half as many new funds starting up next year * * *.” ). Nonetheless, the majority cites Mr. Holzman for the proposition that barriers to entry are low and concludes that “thus the cost of compliance with these rules should not present significant additional barriers to entry for new hedge fund advisers.” Adopting Release at nn. 121-22 and accompanying text.

See Comment Letter of the ICAA (Sept. 14, 2004) (“The fact is that investment adviser regulation and compliance have become increasingly complex and costly.”). See also Comment Letter of Davis, Polk & Wardwell (Sept. 15, 2004) (noting that the costs of registration and compliance are “substantial and increasing” and will be passed on to investors).

See, e.g., Comment Letter of the Managed Funds Association (Sept. 15, 2004) (reporting that one MFA member incurred over $75,000 in staff time in connection with the preparation of Form ADV).

See, e.g., Comment Letter of Guy P. Lander (Sept. 15, 2004) (reporting that client anticipates spending more than $300,000 in the first year to come into compliance with the rulemaking); Comment Letter of the Managed Funds Association (Sept. 15, 2004) (MFA members report incurring more than $300,000 in outside legal and other expenses associated with registration and compliance requirements); Comment Letter of C. Peter Marin, Superior Capital Management LLC (Sept. 8, 2004) (estimating that compliance costs will be 15-20% of revenues of adviser to small hedge fund); Comment Letter of Millrace Asset Group (Sept. 15, 2004) (hedge fund adviser anticipates having to increase staff from four to five to handle compliance under the rulemaking); Comment Letter of Seward & Kissel LLP (Sept. 15, 2004) (“To properly fulfill the breadth of compliance requirements under the Advisers Act, many advisers would be required to hire at least one additional professional at a cost far greater than the estimate provided.”). The majority did not attempt to estimate ongoing compliance and examination costs because of the difficulty of doing so, dismisses the estimates it received as “not representative,” and instead offers the observation that “one registered hedge fund adviser commented that the firm itself derived benefit from the examination process.” Adopting Release at IV.B.3.

The majority explains this failure and its rejection of commenters' estimates by noting that advisers are not required to hire someone to fill the role and the chief compliance officer can have responsibilities. See Adopting Release at text following n. 335. The majority did not attempt to estimate the real, quantifiable cost of the requirement on firms, which must allocate at least a portion of an employee's time to handling the increased compliance functions. See Adopting Release at Section IV.B.2.

See, e.g., David R. Sawyer (Sidley, Austin, Brown and Wood) (Sept. 14, 2004) (reporting that two clients, hedge fund advisers, spent between $300,000 and $500,000 preparing for and hosting examiners, without including opportunity costs).

Adopting Release at n. 116. The staff, in its hedge fund report, noted: “We are concerned about our inability to examine hedge fund advisers and evaluate the effect of the strategies used in managing hedge funds on our financial markets.” 2003 Staff Hedge Fund Report, supra n., at 11. Certainly, then, hedge fund advisers can anticipate that the staff will be looking into, and perhaps regulating, such strategies.

Comment Letter of Guy P. Lander (Sept. 15, 2004). See also Comment Letter of the U.S. Chamber of Commerce (Sept. 15, 2004) (advisers might avoid innovative strategies in order to avoid Commission scrutiny).

See, e.g., Alan Greenspan, Chairman, Federal Reserve Board, Testimony before the Senate Banking, Housing and Urban Affairs Committee (July 20, 2004) (“Should the existing proposal fail in achieving its goal, pressure will become irresistible to expand SEC's regulatory reach in an endeavor to accomplish what it set out to do. Hedge fund arbitrageurs are required to move flexibly and expeditiously if they are to succeed. If placed under increasing restrictions, many will leave the industry, to the significant detriment of our economy.”). See also Comment Letter of the International Swaps and Derivatives Association (Sept. 15, 2004) (registration will reduce the number of entrants into the hedge fund industry and force others offshore, which will harm the derivatives industry and the market as a whole); Comment Letter of the Financial Services Roundtable (Sept. 15, 2004) (rulemaking might deter “the types of innovative and active trading that serve the marketplace as a whole”); Comment Letter of the Managed Funds Association (Sept. 15, 2004) (the rulemaking “has the potential to create inefficiency and instability in our capital markets by stifling the willingness of hedge funds to act as shock absorbers and provide risk capital in times of market instability”); Comment Letter of Seward & Kissel LLP (Sept. 15, 2004) (rulemaking could raise barriers to entry for new advisers); Comment Letter of Tudor Investment Corp. (Sept. 15, 2004). The majority, in faulting commenters opposing the rule for failing to demonstrate “that hedge funds managed by registered advisers play a diminished role in the financial markets compared to hedge funds managed by unregistered advisers,” fails to recognize that the effects of registration might be different for different advisers. Adopting Release at text accompanying n. 71.

The majority's attempt to characterize this as a positive potential effect of the rulemaking is not persuasive. See Adopting Release at Section VII (acknowledging that investors might not be able to select the adviser of their choice, but noting that “a hedge fund adviser's decision not to expand its business may make it easier for other advisers to enter the market.”).

See Bernstein 2004 Report, supra note 21, at 2 (“In general, there are very wide discrepancies in market size and performance estimates from different sources. As an example, we found that among three leading hedge fund data providers only approximately 15 percent of funds were included in all three databases.”); see also supra note 60.

Adopting Release at text accompanying n. 119.

See, e.g., Comment Letter of Madison Capital Management LLC (Sept. 15, 2004) (predicting that the rulemaking will have the effect of inducing hedge funds to admit retail investors).

15 U.S.C. 80b-8(a).

See amended rule 203(b)(3)-1(d).

See, e.g., Comment Letter of the CFA Institute Center for Financial Market Integrity (Sept. 30, 2004) (noting that the two year redemption criterion “would seem to us to be somewhat arbitrary”); Comment Letter of Madison Capital Management LLC (Sept. 15, 2004) (“the majority's ‘private fund’ centered regulatory scheme creates an arbitrary distinction among funds”); Comment Letter of the North American Securities Administrators Association (“NASAA feels that the definition of ‘Private Fund’ is ineffective at distinguishing hedge funds from private equity, venture capital and commodity pools.”).

See, e.g., Comment Letter of Gibson, Dunn & Crutcher LLP (Sept. 13, 2004) (“this component is the only factor in the Rule itself that can be relied upon to exempt traditional private equity and venture capital funds”).

Comment Letter of the Financial Services Roundtable (Sept. 15, 2004) (rule will reach some private equity and real estate fund advisers); Commenter Letter of Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP. (Sept. 15, 2004) (requesting narrower definition of “Private fund” to avoid including other types of investment vehicles).

See, e.g., Comment Letter of Ellington Management Group LLC (Sept. 15, 2004) (“The industry `buzz'; is that, in fact, many hedge fund managers wishing to avoid registration will be trying to institute two-year lockups exactly for this purpose.”); Comment Letter of the Greenwich Roundtable (Sept. 15, 2004); Comment Letter of Jeffrey R. Neufeld (Sept. 15, 2004).

The majority inappropriately looks to ease of redeemability as evidence that “hedge fund advisers are effectively providing advisory services to the fund's investors.” See Adopting Release at n. 237.

See, e.g., Comment Letter of the Greenwich Roundtable (Sept. 15, 2004) (“If the intention of the Rule is to specifically exclude venture capital and private equity funds, then those funds can more easily be excluded without harming genuine hedge fund investors. We would suggest instead that the Rule apply a test that focuses on the marketability of a fund's holdings, rather than on an investor's willingness to lock-up an investment.”); Comment Letter of Kynikos Associates (Sept. 15, 2004) (recommending distinguishing funds on the basis of “investment characteristics”); Comment Letter of the North American Securities Administrators Association (recommending a test based on frequency with which securities in fund are traded). See also Comment Letter of Ellington Management Group LLC (Sept. 15, 2004) (recommending distinguishing hedge funds from other types of private investment funds by looking at how the fund employs net asset value in determining management fees and setting purchase price and redemption fees). The majority explains that it rejected this approach in order to prevent advisers from altering their investment strategies to avoid registration. See Adopting Release at n. 225. It is much easier for advisers to alter their redemption period in order to avoid registration.

See, e.g., Comment Letter of Kynikos Associates (Sept. 15, 2004) (noting that while venture capital and private equity funds are “somewhat different” from hedge funds, the Commission's concerns, including particularly valuation, are nevertheless applicable); Comment Letter of Leon M. Metzger (Sept. 15, 2004) (interim valuations matter for other types of private funds, e.g., for purposes of the valuation of a deceased investor's estate ); Comment Letter of the Committee on Private Investment Funds, The Association of the Bar of The City of New York (Sept. 15, 2004) (although of “more limited relevance,” in the venture capital and private equity context, valuation is important for purposes such as investor reporting, and marketing follow-on funds).

Comment Letter of the National Venture Capital Association (Sept. 15, 2004) (“NVCA believes that the [proposing] Release and the proposed rule create a risk of future burdensome regulation on venture capital that outweighs any investor protection benefit that would come from the proposed rule.”).

The majority also argues that the third prong of the definition, which limits “private funds” to those that are marketed based on the skills, ability, and expertise of the adviser, “confirm[] the direct link between the adviser's management services and the investors.” Adopting Release at text preceding n. 168. If this reasoning is sound with respect to hedge funds, the same link exists between investors in venture capital and private equity funds and the advisers of those funds.

15 U.S.C. 80b-3(b)(3). When Congress amended section 203(b)(3) in 1980 to preclude looking through business development companies in counting clients for purposes of that section, Congress did not “intend to affect adversely the status of investment advisers which are not registered under the Act.” H.R. Rep. No. 96-1341, at 62 (1980).

The Commission explained that this safe harbor was “not intended to specify the exclusive method for a limited partnership, rather than each limited partner, to be counted as a ‘client’ for purposes of section 203(b)(3) of the Act.” Definition of “Client” of an Investment Adviser for Certain Purposes Relating to Limited Partnerships, Investment Advisers Act Release No. 983 (July 12, 1985) [50 FR 29206 (July 18, 1985)].

See, e.g., Definition of “Client” for Certain Purposes Relating to Limited Partnerships, Investment Advisers Act Release No. 956 (Feb. 25, 1985) [50 FR 8740 (Mar. 5, 1985)] (“Where an adviser to an investment pool manages the assets of the pool on the basis of the investment objectives of participants as a group, it appears appropriate to view the pool—rather than each participant—as a client of the adviser.”).

See Status of Investment Advisory Programs under the Investment Company Act of 1940, Investment Company Act Release No. 22579 (Mar. 24, 1997) [62 FR 15098 (Mar. 31, 1997)] (adopting rule 3a-4 under the Investment Company Act [17 CFR 270.3a-4(a)] to provide a nonexclusive safe harbor from the definition of investment company for certain programs under which investment advisory services are provided on a discretionary basis to a large number of advisory clients having relatively small amounts to invest). Among the safeguards in the rule is a requirement that the sponsor of the program must obtain sufficient information from each client to be able to provide individualized investment advice to the client and periodically update the information. See rule 3a-4(a)(2). The majority, in support of its approach, posits a situation in which a group of individual clients of an adviser is combined into a hedge fund in order to avoid application of the Advisers Act. The majority's hypothetical example does not tell us whether the investors continue to receive personalized advice. See Adopting Release at text accompanying nn. 177-78. If they do not, there is nothing inappropriate about the adviser's characterizing the group as an unregistered investment company; they should be characterized as such, so long as they meet the applicable criteria to be classified as a private investment company.

Status of Investment Advisory Programs under the Investment Company Act of 1940, Investment Company Act Release No. 22579 (Mar. 24, 1997) [62 FR 15098 (Mar. 31, 1997)].

In instances in which an entity is merely a legal artifice, advisers, of course, are prohibited from counting it, rather than its investors, as clients in order to avoid registration. See section 208(d) of the Advisers Act [15 U.S.C. 80b-8d] (making it “unlawful for any person indirectly * * * to do any act or thing which it would be unlawful for such person to do directly.”). This does not describe the hedge funds the advisers of which are the intended targets of the new rulemaking.

See, e.g., Comment Letters of Schulte Roth & Zabel LLP (Sept. 15, 2004); U.S. Chamber of Commerce (Sept. 15, 2004); Willkie, Farr & Gallagher (Sept. 13, 2004), Wilmer Cutler Pickering Hale and Dorr, LLP (Sept. 8, 2004).

The majority speculates that Congress might not have intended for the legal entity to be treated as the client in the hedge fund context as it is in the investment company context. See Adopting Release at n. 171. But for their ability to rely on statutory exemptions from the definition of “investment company” under the Investment Company Act, hedge funds generally would fit within the definition. The approach of treating the entity, not the investors, as the client is equally appropriate in both cases.

Investment Advisers Act, Section 203(b), Pub. L. 76-768, 54 Stat. 847, 850 (1940).

See Investment Company Act Amendments of 1970, H.R. Rep. No. 91-1382, at 39 (1970).

Section 203(c)(2) of the Advisers Act [15 U.S.C. 80b-3(c)(2)] permits the Commission, after notice and opportunity for a hearing, to deny registration to an adviser that is subject to disqualification under section 203(e) [15 U.S.C. 80b-3(e)]. Item 11 of Part 1 of Form ADV requires applicants for registration as an investment adviser to report felonies and other disciplinary events occurring during the last 10 years. The Commission's screening, however, does not rely exclusively on an applicant's self-reporting of violations; our staff checks applicants against a large database of securities violators to determine whether there are any unreported disciplinary events.

See, e.g., SEC v. J. Scott Eskind, supra note (Eskind, already barred by the Commission from association with any investment adviser, raised more than $3 million from investors for a purported hedge fund, and simply misappropriated it); SEC v. Sanjay Saxena, Litigation Release No. 16206 (July 8, 1999) (Saxena, already barred by the Commission from the securities industry, defrauded hedge fund investors of approximately $700,000).

SEC v. Jean Baptiste Jean Pierre, Gabriel Toks Pearse and Darius L. Lee, supra note (defendants raised nearly half a million dollars, the majority of which were simply misappropriated by Jean Pierre); SEC v. Peter W. Chabot, Chabot Investments, Inc., Sirens Synergy and the Synergy Fund, LLC, supra note 97 (Chabot raised over $1.2 million for an alleged hedge fund but did not buy any stocks or other securities with the funds, instead using the money for his personal expenses).

15 U.S.C. 80a-3(c)(7).

S. Rep. 104-293, at 10 (1996).