SEC Chief Threatens Hedge Funds With Regulation

by Carla Johnson, Investors Offshore, New York

28 May 2002

New Chairman of the US Securities and Exchange Commission, Harvey L Pitt, succeeding the 'now follow that' triumph of Arthur Levitt, set out his stall in some detail at the 2002 General Meeting of the Investment Company Institute last Friday, talking about "negative forces afflicting our securities markets, that have eroded the critical reservoir of investor confidence" and "the lack of public confidence in the securities industry, the accounting and legal professions, and those of us who regulate them."

Mr Pitt bravely reminded his professional audience that: "investors are appalled that:

• securities analysts tout securities, but don't believe the recommendations they make, and don't mention that fact in giving their recommendations;
• valued brokerage firm customers are given investment opportunities, but only in return for kickbacks to the brokerage firms that made the opportunities available;
• public companies comply with disclosure obligations solely for the purpose of fending off potential liability claims, rather than for the purpose of telling investors how the company really is doing;
• public companies employ accounting principles designed to obscure the real performance of the company, rather than elucidate it;
• public companies issue so-called pro forma financial statements to convert losses into the appearance of profits; and
• accountants make it possible for companies to engage in alchemy to convert a sow's ear into a silk purse — that is, to permit corporate clients to use accounting principles to obfuscate a company's true financial posture and hide impending disaster."

Indeed these practices are appalling; but they are so deeply woven into the fabric of US (and international) securities markets, and so well understood, that only a highly naive investor could be unaware of them. So if Mr Pitt truly means to take them on, he has a fight on his hands.

"The real challenge of these times is restoring and rebuilding our traditions of integrity, ethical behavior, fiduciary obligations, basic honesty and decency, said Mr Pitt. "All of us must join together and demand or support the changes necessary to restore integrity, to restore investors' faith in our capital markets."

The SEC Chairman identified three key areas that need substantial improvement: disclosure by public companies must be truly informative, timely, and honest; oversight of accountants and the accounting profession must be strengthened and accounting principles that underlie financial disclosures must be made more relevant and comprehensible; and corporate governance must be upgraded.

Mr Pitt said that the SEC was moving forward with the development of a new independent oversight board to govern the public accounting profession. A "Public Accountability Board" was envisaged, separate from, and independent of, the profession, and operating under rigorous SEC oversight, which would directly review accounting firms' quality controls over their accounting and auditing practices.

Among significant initiatives which the new Chairman said had already been undertaken were those concerning mutual fund advertising and disclosure, which would require fund advertisements to convey more balanced information to prospective investors, particularly with respect to past performance, would require fund advertisements that contain performance information to direct investors to a toll-fee or collect telephone number (and perhaps Web site) to obtain the most recent month-end performance information for a fund's 1-, 5- and 10-year periods, and would require advertisements to improve narrative disclosures to explain the limits of past performance data and the importance of fund fees and expenses.

Mr Pitt said that the SEC was anxious to undertake a fresh look at its prior guidance concerning electronic delivery of information under the federal securities laws. "Our regulations," he said, "must keep pace with product innovation as well as investor demands and needs."

Referring to hedge funds, the Chairman noted that: "Private investment funds are structured to avoid direct regulation. By all accounts, private investment funds have experienced a seismic boom in both number and total assets under management. But, since these entities are not subject to reporting requirements, the information we have about them is sketchy. We are concerned about the implications flowing from the growth in these private investment funds. Accordingly, we will seek a better understanding of the issues currently affecting these vehicles by commencing a formal fact-finding investigation to enlighten us about:

• incidents of fraud that we have seen with certain of these vehicles, particularly hedge funds;
• conflicts associated with managing these vehicles alongside mutual funds; and
• marketing these vehicles directly and indirectly to retail investors.

" Our goal," he said, "is to determine whether the present state of regulation — or perhaps more accurately the lack thereof — is in the public interest."

If Mr Pitt is even partly as good as his words, it seems unlikely that the existing regime enjoyed by hedge funds and other private investment vehicles will be enjoying its place in the sun for much longer without substantially greater regulation.

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