<DOC>
[110th Congress House Hearings]
[From the U.S. Government Printing Office via GPO Access]
[DOCID: f:40871.wais]
AFTER BLACKSTONE: SHOULD SMALL INVESTORS BE EXPOSED TO RISKS OF HEDGE
FUNDS?
=======================================================================
HEARING
before the
SUBCOMMITTEE ON DOMESTIC POLICY
of the
COMMITTEE ON OVERSIGHT
AND GOVERNMENT REFORM
HOUSE OF REPRESENTATIVES
ONE HUNDRED TENTH CONGRESS
FIRST SESSION
__________
JULY 11, 2007
__________
Serial No. 110-42
__________
Printed for the use of the Committee on Oversight and Government Reform
Available via the World Wide Web: http://www.gpoaccess.gov/congress/
index.html
http://www.oversight.house.gov
U.S. GOVERNMENT PRINTING OFFICE
40-871 WASHINGTON : 2008
_____________________________________________________________________________
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COMMITTEE ON OVERSISGHT AND GOVERNMENT REFORM
HENRY A. WAXMAN, California, Chairman
TOM LANTOS, California TOM DAVIS, Virginia
EDOLPHUS TOWNS, New York DAN BURTON, Indiana
PAUL E. KANJORSKI, Pennsylvania CHRISTOPHER SHAYS, Connecticut
CAROLYN B. MALONEY, New York JOHN M. McHUGH, New York
ELIJAH E. CUMMINGS, Maryland JOHN L. MICA, Florida
DENNIS J. KUCINICH, Ohio MARK E. SOUDER, Indiana
DANNY K. DAVIS, Illinois TODD RUSSELL PLATTS, Pennsylvania
JOHN F. TIERNEY, Massachusetts CHRIS CANNON, Utah
WM. LACY CLAY, Missouri JOHN J. DUNCAN, Jr., Tennessee
DIANE E. WATSON, California MICHAEL R. TURNER, Ohio
STEPHEN F. LYNCH, Massachusetts DARRELL E. ISSA, California
BRIAN HIGGINS, New York KENNY MARCHANT, Texas
JOHN A. YARMUTH, Kentucky LYNN A. WESTMORELAND, Georgia
BRUCE L. BRALEY, Iowa PATRICK T. McHENRY, North Carolina
ELEANOR HOLMES NORTON, District of VIRGINIA FOXX, North Carolina
Columbia BRIAN P. BILBRAY, California
BETTY McCOLLUM, Minnesota BILL SALI, Idaho
JIM COOPER, Tennessee JIM JORDAN, Ohio
CHRIS VAN HOLLEN, Maryland
PAUL W. HODES, New Hampshire
CHRISTOPHER S. MURPHY, Connecticut
JOHN P. SARBANES, Maryland
PETER WELCH, Vermont
Phil Schiliro, Chief of Staff
Phil Barnett, Staff Director
Earley Green, Chief Clerk
David Marin, Minority Staff Director
Subcommittee on Domestic Policy
DENNIS J. KUCINICH, Ohio, Chairman
TOM LANTOS, California DARRELL E. ISSA, California
ELIJAH E. CUMMINGS, Maryland DAN BURTON, Indiana
DIANE E. WATSON, California CHRISTOPHER SHAYS, Connecticut
CHRISTOPHER S. MURPHY, Connecticut JOHN L. MICA, Florida
DANNY K. DAVIS, Illinois MARK E. SOUDER, Indiana
JOHN F. TIERNEY, Massachusetts CHRIS CANNON, Utah
BRIAN HIGGINS, New York BRIAN P. BILBRAY, California
BRUCE L. BRALEY, Iowa
Jaron R. Bourke, Staff Director
C O N T E N T S
----------
Page
Hearing held on July 11, 2007.................................... 1
Statement of:
Bullard, Mercer E., University of Mississippi Law School;
John C. Coffee, Jr., Columbia Law School; Joseph P. Borg,
president of the Board of Directors of the North American
Securities Administrators Association; and Peter J. Tanous,
president and CEO, Lynx Investment Advisory, LLC........... 40
Borg, Joseph P........................................... 100
Bullard, Mercer E........................................ 40
Coffee, John C., Jr...................................... 85
Tanous, Peter J.......................................... 111
Donahue, Andrew J. ``Buddy'', Director of the Division of
Investment Management, Securities and Exchange Commission.. 19
Letters, statements, etc., submitted for the record by:
Borg, Joseph P., president of the Board of Directors of the
North American Securities Administrators Association,
prepared statement of...................................... 103
Bullard, Mercer E., University of Mississippi Law School,
prepared statement of...................................... 43
Coffee, John C., Jr., Columbia Law School, prepared statement
of......................................................... 88
Donahue, Andrew J. ``Buddy'', Director of the Division of
Investment Management, Securities and Exchange Commission,
prepared statement of...................................... 22
Issa, Hon. Darrell E., a Representative in Congress from the
State of California, prepared statement of................. 11
Kucinich, Hon. Dennis J., a Representative in Congress from
the State of Ohio, prepared statement of................... 4
Tanous, Peter J., president and CEO, Lynx Investment
Advisory, LLC, prepared statement of....................... 113
AFTER BLACKSTONE: SHOULD SMALL INVESTORS BE EXPOSED TO RISKS OF HEDGE
FUNDS?
----------
WEDNESDAY, JULY 11, 2007
House of Representatives,
Subcommittee on Domestic Policy,
Committee on Oversight and Government Reform,
Washington, DC.
The subcommittee met, pursuant to notice, at 1 p.m., in
room 2154, Rayburn House Office Building, Hon. Dennis J.
Kucinich (chairman of the subcommittee) presiding.
Present: Representatives Cummings, Kucinich, Davis of
Illinois, Tierney, Watson, Braley, Cannon, Issa, and Bilbray.
Also present: Representative Hodes.
Staff present: Jaron Bourke, staff director; Charles Honig,
counsel; Jean Gosa, clerk; Evan Schlom, intern; Natalie Laber,
press secretary, Office of Congressman Dennis J. Kucinich;
Leneal Scott, information systems manager; and David Marin,
minority staff director.
Mr. Kucinich. Good afternoon. The Subcommittee on Domestic
Policy of the Committee of Oversight and Government Reform will
now come to order.
Today's hearing will take a closer look at loosened initial
public offerings of hedge funds and private equity funds and
the risks they pose to small investors.
Without objection, the Chair and ranking minority member
will have 5 minutes to make opening statements, followed by
opening statements not to exceed 2 minutes by any other Member
who seeks recognition.
Without objection, Members and witnesses may have 5
legislative days to submit a written statement or extraneous
materials for the record.
Without objection, we will be joined on the dias by Members
not on our committee for the purposes of participating in this
hearing and asking questions of our witnesses.
Good afternoon. This hearing's purpose is to shed light on
a serious challenge to America's decades-long commitment to
protecting small investors, brought to public attention by the
recent public offering of Blackstone LP. Hedge funds and
private equity funds are risky, and they operate under
exemptions from traditional investor protections.
Under current law, hedge funds and private equity funds may
not be sold to small investors. They deploy investment
strategies that are otherwise prohibited, and they possess the
potential for rich rewards. But at the same time, they are
characterized by real potential risks of callosal failure,
illustrated by the collapse of two Bear Sterns hedge funds just
2 weeks ago, and the collapse of Amaranth Partners and Long
Term Capital some years ago.
The public offering of Blackstone LP 2 weeks ago and the
offering of the Fortress Investment Group that preceded it
marked the attempt to mainstream a new financial arrangement
that effectively presents small investors with the ability to
invest in the management of hedge funds and private equity
funds. I am concerned that the effect is to expose small
investors to risks that heretofore have been permitted only for
large institutional investors and wealthy individuals.
Blackstone is the latest and by far the largest family of
hedge funds and private equity funds that have devised a way to
be traded publicly without compliance with the Investment
Company Act of 1940, but it by no means will be the last. The
Kohlberg, Kravis, Roberts private equity group and the Och-Ziff
Capital hedge funds have already filed with the SEC to make
their management companies public following Fortress and
Blackstone models, and news reports indicated that other funds,
such as the Carlyle Group and Apollo may not be far behind.
The subject of this hearing is this: has the SEC adequately
used its existing authority to protect small investors with
regard to the initial public offering of these arrangements? Is
the existing law adequate to the task of protecting investors
in the face of the desire and resourcefulness of hedge fund and
private equity fund managers to go public? What are the new
risks to small investors posed by these new financial
arrangements?
I want to be clear that this hearing is not about the
abolition or even the further regulation of private equity and
hedge funds, nor is this hearing biased toward forbidding
future offerings like Blackstone LP. The bias, if there is one,
is toward the protection of small investors and how best
regulation may accomplish that goal; in other words, what steps
all actors in the broader regulatory system, including
Congress, can and should take to militate against the risk of
these novel investment vehicles.
The backbone of our financial system, one that makes it the
envy of the world and an efficient machine to balance risk and
reward, is our strong system of regulating public offerings.
The Securities and Exchange Commission has attempted to
institute some regulation of hedge funds for even sophisticated
and wealthy investors. All of the witnesses that you will hear
from today think that when small investors are allowed access
to hedge funds and private equity funds there needs to be
regulation. The question is: what type of regulation is both
necessary and reasonable to strengthen our financial system?
Blackstone LP provides the point of departure. This
subcommittee wrote the SEC on June 21st out of concern that
insufficient time an opportunity had been allotted to examine
those new risks and the soundness of the new financial
arrangements. Chairman Waxman and I felt that the stakes were
high, since a careful reading of Blackstone's registration
statements by our staff revealed that public investors in the
IPO would be assuming risks without the traditional investor
protections of corporate governance that allow investor control
and without transparency and the disclosure of what is being
invested in. Those risks include excessive compensation
arrangements, management of self-dealing transactions with
affiliates, use of substantial leverage, no diversification
requirements, difficult-to-value investments, illiquid
investments, no independent board members, no substantive
voting rights, few fiduciary duties on management.
Eagerness by Blackstone to launch this IPO and to stymie
Congress' examination of these questions is unfortunate. It
should be noted that Blackstone moved up its offering date by a
week, precisely when we and several other Members of Congress
asked the SEC to scrutinize further the offerings. They could
have allowed the inquiry to take place, and I believe it was
unfortunate they didn't. But if Blackstone was able to market a
black box to ordinary investors by gaming their offering date,
others that follow will not.
The alternative to oversight is not pretty: it is to wait
for something bad to happen; for the failure of one or several
of these management complaints; and for, as in the Enron
debacle, ordinary investors to lose everything, including their
retirement income, and to allow the legal and economic fallout
to be resolved through protracted and expensive litigation. You
know, this just isn't acceptable.
So our hearing today is timely and, we hope, helpful to the
cause of protecting ordinary investors. These are individuals
and families who are saving for college or retirement through
IRAs and 527s, mutual funds, and online trading houses. They
depend upon the SEC and Congress to afford them the
opportunities of our market system with protections from
excessive risks and dangers which can otherwise ruin and defeat
the American dream.
We will examine today, with the help of some of the
Nation's leading experts, if we are living up to that challenge
and if we are responsibly or irresponsibly exposing small
investors to excessive risk and danger.
Thank you very much.
[The prepared statement of Hon. Dennis J. Kucinich
follows:]
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Mr. Kucinich. With that I recognize the Honorable ranking
minority member, Mr. Issa of California.
Mr. Issa. Thank you, Mr. Chairman. I think you did a great
job of characterizing the majority opinion on today's hearing,
and Ido want to thank you very sincerely for holding this. I
believe that there is a need for this Congress to view changes
in the market, and view them with the kind of doubt that, by
definition, helps protect investors large and small.
I do believe that we are holding two hearings here today.
We are holding on that seems to be all about Blackstone. This
IPO was not a private equity, in fact, public offering, but
rather the management of a private equity. But we are also here
today, without a doubt, dealing with questions of hedge funds
and private equity that are being dealt with in Congress as we
speak and that are being, in some cases, vilified.
So little is known about private equity industry it is easy
to mischaracterize the role they play in our economy. My
comments today are directed primarily at private equity funds.
I am concerned that we in Congress are lumping equity and hedge
funds together and looking at them as interchangeable. They are
different entities and should be seen differently.
Frequently we have heard individuals such as Steve
Schwartzman of Blackstone or Lew Gerstner of the Carlyle Group
characterized as Masters of the Universe, invoking images of
robber barons or captains of industry, to explain the business
model. What is more, in every article concerning Blackstone's
IPO, there were also descriptions of CEO's lavish lifestyle.
These notions have led Members of Congress to advocate for
increasing taxes associated with the private equity model.
Included today I put some charts up--and I have more--that
specifically make it clear that one of the major recipients of
both hedge funds and private equity are, in fact, both public
and private entities such as union pension funds, public
pension funds, and, in fact, corporate pension funds typically
having between 1 and 15 percent of their portfolio in these
types of investments. These investments have done well for
future retirees throughout the country, running as much as 22,
23 percent return on investment year over year over year.
So it is very clear that the most sophisticated buyers, the
most sophisticated buyers, these large, multi-billion-dollar
pension funds with all of their professional management, have
made a decision that favors a certain percentage of these
investments.
It is also clear that if, not as this chairman, but as
chairmen of some other committees, have been advocating, if, in
fact, we choose to add a level of taxation to this process at
any point, we are not going to take it out of the people and
the companies that produce these profits; we are going to take
it out of the pass-along to these entities. That is one of my
concerns here today.
Perhaps as a proud Republican, perhaps simply as a
taxpayer, I find little doubt in my mind that we are taxed
sufficiently. I am not here today to advocate for a tax
increase. In fact, my opinion is that we, as Americans, are
fully taxed and need not look for additional tax revenue by
adding to a group to vilify in order to raise their taxes.
Also, too often securities legislation has been the product
of congressional hothouses. This follows closely on financial
scandals or disasters. It is no coincidence that Congress
passed the Security Exchange Act of 1933 or created the
Securities and Exchange Commission in 1934 following the dark
days of the 1929 crash and the Depression that followed.
In recent history, Congress passed during my tenure
Sarbanes-Oxley Act on the heels of Enron and WorldCom
disasters. Oddly enough, Sarbanes-Oxley did little to prevent
that from happening again, but has added billions of dollars of
legal and accounting costs to public companies, thus reducing
what they can pay in dividends to the small investor that we
are here today to talk of.
It is very clear that we are not here today to pass
legislation in a hurry. It is clear that we should not. There
has not been a disaster. There has not been some sort of an
episode, including this public offering, that should cause us
to hastily go to legislation. Just the opposite. I believe
hearing from the Securities and Exchange Commission and from
career investors and other people knowledgeable in this
industry today, we will have a better opportunity to see what
is right, what is more right in this country than any other
country on the face of the Earth, and then perhaps what could
be done. Perhaps we could start talking about rolling back some
of the mistakes of Sarbanes-Oxley.
Thankfully, the debate about Blackstone IPO will not result
in a public scandal. It will and has resulted in small
investors able to participate in just a few thousand dollars, a
few hundred shares, if they choose to, in fact, the management
team of a company that has been wildly successful.
Full disclosure, not just by the SEC but also, and I think
more importantly, by the public media has made it very clear
that this is a unique first event and that investors should
make sure that they are not over-weighted in this or any other
investment.
Mr. Chairman, not to be overly colorful, but because I am a
believer that America's competitiveness depends on private
equity, I am going to close and put the rest in for the record
and just tilt up one example. I used wine with Chairman Waxman
not too long ago, but Dunkin Donuts, a small public company
that went private, in my opening statement I characterize they
have made it very clear that their success today, in fact, the
fact that they are doing a very good job against their best-
known rival, Krispy Kreme--since I am putting out public names
of which I own none--they, in fact, could not have reorganized
and come out a much more successful company if they didn't have
the ability to come out of the daily quarterly grind, make the
kinds of investments that often we on the dais complain are
short-sighted, the I have to make this quarter, the next
quarter that public companies often do. But instead, they were
able to put together a long-term plan, come out, and, in fact--
and the odor is absolutely wonderful--produce a product that
now is selling dramatically better than it did just a few years
ago.
Mr. Chairman, I will put the rest in for the record and
make the donuts available to all of our guests. [Laughter.]
I will yield back.
[The prepared statement of Hon. Darrell E. Issa follows:]
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Mr. Kucinich. I want to thank my friend for his
presentation and say that we shall proceed in the spirit of
keeping our eye on the donut and not on the hole. [Laughter.]
I am a vegan. I don't eat that stuff.
The Chair will recognize the distinguished Member of
Congress from New Hampshire, Mr. Hodes, who is a guest at our
committee.
We welcome you.
Mr. Hodes. Thank you, Mr. Chairman. I appreciate your
allowing me to sit as a guest member of the subcommittee. I am
a member of the Oversight and Government Reform Committee and
also a member of the Financial Services Committee, and am
especially interested in the Blackstone matter.
I had a pleasure, as a member of the Financial Services
Committee, Mr. Donahue, to question Chairman Cox and the
Commissioners of the SEC about the Blackstone IPO because of
some particular concerns I had.
Now, I am not here to argue between tempe and tofu or one
wine or the other, and I understand that the SEC has held that
the Blackstone IPO did not have to comply with the Investment
Company Act of 1940.
My concern remains, however, and I suppose that reasonable
minds could differ on the SEC's conclusion, and reasonable
minds do, and the courts could take it up, and they may. But my
question really--and I am hoping you will address this--is that
it is a public policy question. The SEC's mission is to protect
investors; maintain fair, orderly, and efficient markets; and
facilitate capital formation.
We are now in a new world in which a private equity firm,
Blackstone, probably very different than a traditional, if such
can be applied to the word hedge fund, has now gone public.
They have made the transition from the private equity entity
into the public markets.
In that light, according to their S-1 filing and what is
generally recognized in the way they are formed, they have
disclaimed fiduciary duties in general to their unit holders,
they have limited voting rights to their unit holders, and they
have asserted the right to act with limited disclosure as to
important elements of their strategy and the way they operate
which would otherwise, in the ordinary course of a public
offering which did comply with the Investment Company Act of
1940, be available to their shareholders or unit holders.
I think significant public policy questions are raised, and
it is not too early, given the size and complexity of the
Blackstone IPO and other private equity firms which appear to
be coming to the market, to ask the question whether or not, in
view of this new entity, the Investment Company Act of 1940 is
up to date, and whether or not amendments need to be made to
respond to the new situation in the markets in order to protect
investors, because for the life of me I cannot see who is
protecting the investors in the Blackstone IPO if they are
allowed to disclaim their fiduciary duties, and how and by what
mechanism that will happen.
I understand that the SEC is moving on some elements to
deal with fraud provisions that might relate, but it strikes
me, as a matter of public policy, that we may have to address
the Investment Company Act of 1940, and I look forward to
hearing from you your thoughts on the advisability of doing
that.
Thank you very much.
Thank you, Mr. Chairman.
Mr. Kucinich. I thank the gentleman for joining us.
If there are no additional opening statements, this
subcommittee will now receive testimony from the witnesses
before us today.
I want to start by introducing the gentleman who will be
making the first presentation, Mr. Andrew Donahue. Mr. Donahue
has been the Director of the Division of Investment Management
at the Securities and Exchange Commission since May 2006.
Welcome, Mr. Donahue.
As Director, Mr. Donahue is responsible for developing
regulatory policy and administering the Federal securities laws
applicable to mutual funds, exchange-traded funds, closed-end
funds, variable insurance products, unit investment trust, and
investment advisors. You can see that we have the right person
here to talk to about this.
Prior to the SEC, Mr. Donahue was global General Counsel
for Merrill Lynch Investment Managers and chairman of the
firm's Global Risk Oversight Committee. Prior to his time at
Merrill Lynch, Mr. Donahue was a securities lawyer and
executive vice president and general counsel, director, and
member of the Executive Committee for Oppenheimer Funds.
Mr. Donahue, it is the policy of the Committee on Oversight
and Government Reform to swear in all witnesses before they
testify, and I would ask if at this time you would kindly rise
and raise your right hand.
[Witness sworn.]
Mr. Kucinich. The record will reflect that the witness
answered in the affirmative.
I ask the gentleman to give a brief summary of his
testimony. Keep this summary, if you would, under 5 minutes in
duration. I want you to bear in mind that your complete
statement and anything you want to attach to it will be
included in the hearing record.
The gentleman is recognized. Again, thank you for your
presence here today.
You may proceed.
STATEMENT OF ANDREW J. ``BUDDY'' DONAHUE, DIRECTOR OF THE
DIVISION OF INVESTMENT MANAGEMENT, SECURITIES AND EXCHANGE
COMMISSION
Mr. Donahue. Chairman Kucinich, Ranking Member Issa, and
members of the subcommittee, I am pleased to be here today to
discuss the Securities and Exchange Commission's perspective
with respect to initial public offerings of investment advisory
firms that, among other things, manage hedge and private equity
funds.
As the head of the Commission's Division of Investment
Management, I have responsibilities for overseeing and
regulating nearly 1,000 investment company complexes with over
$11 trillion in assets, and more than 10,000 investment
advisors that manage more than $37 trillion in assets.
A number of issues have been raised about the recent IPOs
of Fortress Investment Group and the Blackstone Group. I am
pleased to be able to offer the committee my knowledge and
expertise, especially as it relates to the question of whether
Fortress and Blackstone are investment companies and thus
subject to the substantive provisions of the Investment Company
Act of 1940.
Congress enacted the Investment Company Act to provide a
separate and different regulatory structure for investment
companies as compared to industrial or operating companies.
Among Congress' stated goals was to minimize the risk that an
investment company might be managed in the interest of its
managers or certain shareholders rather than for the benefit of
all shareholders.
The Investment Company Act provides important protections
to investment company investors. I have great respect for the
Investment Company Act and the role that it has had in
affording America's investors an opportunity to invest in our
Nation's securities markets through a vehicle subject to
meaningful oversight and protection. As a result, I believe
investment companies' status to be a critical determination.
The staff reviewed the Fortress and Blackstone registration
statements in the normal course and consistent with past review
practices and Commission precedent. Applying tests established
by Congress and the Investment Company Act, the staff concluded
that Fortress and Blackstone do not appear to be investment
companies.
First, under the orthodox investment company test, Fortress
and Blackstone are primarily engaged and hold themselves out as
being primarily engaged in the business of managing money for
others, not themselves. Their assets, sources of income,
officer and employee activities, historical development, and
public statements are consistent with those of an operating
company, not an investment company.
Second, in applying the inadvertent investment company
test, Fortress and Blackstone did not appear to have 40 percent
of their assets in investment securities.
In addition to other assets, the primary assets of Fortress
and Blackstone are their general partnership interests and the
underlying funds they manage. These general partnership
interests raise two questions relevant to the investment
company status determinations. First, are they securities or
investment securities? Second, what is their value?
Under existing law, general partnership interests are not
securities if the profits relating to those interests generally
come from the efforts of the general partners, as opposed to
the efforts of others. In the case of Fortress and Blackstone,
the issue is maintained control over the day-to-day management
of the underlying funds, with senior employees exercising such
management through wholly owned subsidiaries.
The profits to the general partnership interest result from
the efforts of the general partnership managers, not others;
thus, the general partnership interest would not constitute
securities or investment securities.
With respect to valuation, the Investment Company Act
requires an issuer to assign a fair value to general
partnership interests like those at issue in Fortress and
Blackstone filings. In determining a fair value, the right to
carried interest in underlying funds may be considered, because
such rights are inexorably linked to the general partnership
interest.
Applying these principles, neither Fortress nor Blackstone
appears to hold investment securities with a value exceeding 40
percent of total assets.
Put another way, in the context of both Fortress and
Blackstone, the value of the assets that are not investment
securities--the general partnership interests, including the
right to receive carried interest in the underlying funds--is
more than 60 percent of total assets.
This asset composition is indicative of an operating
company business rather than an investment company business.
When conducting an investment company status analysis, the
staff considers the status to the relevant entity prior to the
offering, as well as giving effect to the offering. They also
monitor the investment company status of certain companies on
an ongoing basis. In some cases, the staff may disagree with
the investment company's status analysis and request that it
either register as an investment company or restructure its
business or securities holdings so as to no longer be an
investment company. The Commission will bring an enforcement
action against a company in appropriate circumstances.
Our staff did not object to the investment company status
conclusion in the Fortress and Blackstone registration
statements. As noted in the required legends on all registered
public offerings, the Commission does not approve or disapprove
of the securities offered, nor does it pass upon the adequacy
or accuracy of the disclosures. Fortress and Blackstone remain
liable for the statements contained in their registration
statements.
Finally, it is important to consider that the public
investors in Fortress and Blackstone are buying an interest in
an ongoing business which, among other things, manages some
underlying funds. While the value of their investment in
Fortress or Blackstone may be related to how well Fortress or
Blackstone do at managing those underlying funds, as well as
how well Fortress and Blackstone are operating their business,
investors are not acquiring a share in any underlying fund.
Thank you for this opportunity to appear before the
committee. I would be happy to answer any questions you may
have.
[The prepared statement of Mr. Donahue follows:]
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Mr. Kucinich. I thank the gentleman.
I would like to start out by asking you, sir, can you tell
the committee what are some of the investor protections that
follow if an offering is determined by the SEC to be an
investment company?
Mr. Donahue. There is a broad array of investor protection
built into the 1940 act. There are limits on the composition of
the board of directors, there are certain approvals that must
be made by the board of directors of the investment company.
There are provisions that cover the valuation of the assets
that are owned by the investment company. There are limits on
borrowing, senior securities, and leverage. There are limits on
what the capital structure can be. There are limits on
affiliate transactions. There are limits on where assets can be
custodied. And there are very specific requirements with
respect to who the advisor and who the officers and employees
can be for the investment company.
Mr. Kucinich. Thank you. Now, in view of the Securities and
Exchange Commission determination that Blackstone LP was not an
investment company, what investor protections exist now?
Mr. Donahue. The investor protections that exist now for
investors investing in Blackstone and in Fortress are those
that are available to investors in securities that are
registered with the Securities and Exchange Commission that are
not investment companies.
Mr. Kucinich. Let me be more specific, if I may. Under this
determination that Blackstone LP was not an investment company,
do investors have a right to an independent board of directors?
Mr. Donahue. The composition of the board of directors for
that entity, same as for other 1933 Act companies, would be
determined by a combination of State law and the listing
requirements of the exchange that they are traded on.
Mr. Kucinich. So you can't answer yes or no? Is that what
you are saying?
Mr. Donahue. I believe in the case of Blackstone that three
of their seven directors will be independent. That is my
understanding.
Mr. Kucinich. OK. Three of seven. Do they have guaranteed
voting rights under this?
Mr. Donahue. They have the voting rights that are afforded
to them under their governing documents and State law and
Exchange rules, same voting rights as any other 1933 Act
company, same limitations.
Mr. Kucinich. Do they have protections against self-
interested transactions with affiliates?
Mr. Donahue. Not under the Investment Company Act, but they
would have the same protections that might be afforded to other
registered companies.
Mr. Kucinich. Do they have the guarantee of protections of
the traditional range of fiduciary duties owed by management to
shareholders in a corporation such as a duty of loyalty?
Mr. Donahue. They would have the duty that is determined
under State law.
Mr. Kucinich. Now, may I ask you, are hedge funds and
private funds sold today to ordinary investors? If not, why
not?
Mr. Donahue. The hedge funds and private pools of capital,
private funds, can be sold currently to investors, provided
that they are done in accordance with the--generally they use
Regulation D, and in order to avoid registration under the
Investment Company Act they generally comply with the exception
under either 3(c)(1), where there are under 100 investors, or
3(c)(7), where there is unlimited number of investors that all
meet the $5 million or higher test for investments.
Mr. Kucinich. Does the case law in applying the Securities
and Investment Company Act generally support the principle that
function trumps form, or the converse?
Mr. Donahue. As I look at our responsibilities in
administering the securities laws, we are mindful of the
statutory framework within which we have been charged to
operate by Congress, and determinations that have been made by
courts with respect to interpretations. If there is anybody
that felt that this was an investment company in our area, the
protection of investors, we would have sought to see whether or
not there was a way. If we felt that this had been constructed
in a way to evade the Investment Company Act, we certainly
would have taken, I wouldn't say a different look at it, but
you can't evade the Investment Company Act. We did not feel
that was the case here.
Mr. Kucinich. I am going to ask one more question and then
we will probably need to go another round. Will a significant
portion of the value of the units of shares offered to the
public in the Fortress or Blackstone LP deals ultimately be
determined by the returns garnered under the underlying hedge
fund and private equity fund portfolios and move in unison with
the fund portfolios?
Mr. Donahue. I would start off by saying I believe in the
case of Blackstone that they have over 100 underlying
investment funds that it is managing. I would think that the
stock price of Blackstone is going to be driven by a variety of
forces. One certainly I would hope would be how well they would
manage their businesses and how well they are managing their
underlying funds.
It is true that, as currently constituted, a fair amount of
their earnings are derived from how well they manage those
underlying funds, but they are not parting company. They can go
into other businesses. They can create new funds. So going
forward, a lot is dependent not just on their current
investments, the funds that they are managing, but also on how
well they run their management, how well they manage their
company.
Mr. Kucinich. OK. Thank you very much, Mr. Donahue.
The Chair recognizes Mr. Issa. Thank you.
Mr. Issa. Thank you. I want to continue along the line the
chairman was doing. I find this very interesting.
If for a moment, instead of the IPO being about Blackstone
Group, LP, if you were, in fact, investing in Dunkin Donuts,
Hilton Hotels, Linens and Things, as typically people have,
they are investing as limited partners, normally, correct?
Mr. Donahue. I am not familiar with----
Mr. Issa. Their underlying funds are, in fact, typically
Blackstone's----
Mr. Donahue. The underlying funds are typically set up as
limited partnerships.
Mr. Issa. Right.
Mr. Donahue. Yes.
Mr. Issa. And these are sophisticated buyers, usually, if
there are more than 100 of them, and they go in with a portion
of their otherwise high net worth. Many of them, of course, are
public entities and pension funds. And they go in knowing that
they will have absolutely no control; isn't that true? That
limited partners are just what it says, they are limited, they
are in for the ride and for the most part are delineated with
relatively little control, virtually none of the protections
that the chairman talked about?
Mr. Donahue. I would hope they appreciate that.
Mr. Issa. OK. So that wasn't what was offered by the SEC or
reviewed by the SEC. You were reviewing something that had
comparatively a little more protection; would that be fair to
say?
Mr. Donahue. I would say it had considerable disclosure
with respect to the entity that was being----
Mr. Issa. Thank you. I stand corrected. That really is more
accurate, better disclosure. However, in the public disclosure
it was made clear that 78 percent of the interest in this
entity belongs to the partners of Blackstone, the managers, the
people who have made this a successful entity, and only 22
percent was being offered to the public, and of that, half was
going to one investor, China. The other half, 11 percent of
this interest, was going to the public. Is that roughly right,
as you recall?
Mr. Donahue. As I understand it, yes, sir.
Mr. Issa. So there is inherently a, ``We are going to give
you 11 percent of what we get, and the 78 percent is going to
go to us, the managers, and we are going to be in it with what
they like to call in the industry our skin, because we are
going to try to maximize our profits.'' Is that essentially
what this offering was all about?
Mr. Donahue. I don't want to characterize what the offering
was all about, but certainly the sale of the units to public
investors was enabling the public investors to share in the
success of the operating company that they had.
Mr. Issa. Now I am going to call your attention to those
things that you can't possibly read over there, even though we
made them as large as possible.
Mr. Kucinich. Would the gentleman yield? Is there a way, if
you have those on a transparency, maybe we could put them up.
Mr. Issa. We will make it available. I will just
characterize it until they get it up on the slide.
Public entities such as the Ohio Teachers Retirement,
California's PERS and STERS, both the teachers and the public
employees, they are typically running from 5 to 15 percent of
their portfolio in private equity. For purposes of, I think,
the public and Members here today, those percentages show that,
in fact, private equity is something that you might want to
have some of, but you wouldn't want to necessarily have only
that. Is that fair to say, from your experience, because I am
calling on your private life in addition to your current job.
Mr. Donahue. If I could answer from my prior life and not
my current responsibility----
Mr. Issa. Your prior life would be fine. You are an expert
in that area.
Mr. Donahue. Well, I don't know that I would characterize
myself as an expert, but certainly certain asset classes--and I
think private equity is in there--for purposes of
diversification, having a portion of your investments in those
types of investments may be appropriate for you, depending on
your circumstances.
Mr. Issa. And I am going to need a second round, too, but I
will just do one more on this round and then we will come back
to some of the other details.
When Goldman Sachs went public, Senator Corzine, now
Governor Corzine, or, as we call him Seatbelt Corzine around
here--he is going to be an advocate for seatbelt safety, I am
sure--made at least $233 million on that public offering. Would
you, for our edification, characterize why Goldman Sachs was
one type of entity, why Blackstone is another type, and how, if
you are familiar with both of these, how you would deal with
it. I realize that you were a Merrill Lynch guy, but you may
have looked over your shoulder at Goldman Sachs at some point.
I think that will help us in understanding what an investment
company is, etc.
Mr. Donahue. This is based on imperfect knowledge. I would
first say that many indeed would have loved to have been at
Goldman Sachs when they went public, but the businesses of
Goldman Sachs--investment banking, global market trading, asset
management, and brokerage--are businesses that are traditional
investment banking brokerage type businesses. A portion of what
they do would be in the realm of what Blackstone and Fortress
do, so they would have units that would do similar things, but
it wouldn't be, obviously, as much of the particular entity as
exists in a Blackstone case, the way I would characterize the
differences there.
Mr. Issa. OK. And that was where the 40 percent threshold
and these other considerations makes it black and white as to
how you would deal with an entity like Goldman Sachs, even if
they were not a corporation, but Goldman Sachs versus
Blackstone.
Mr. Donahue. With respect to Goldman Sachs, I truly believe
that the status determination would have been simpler,
obviously, than Blackstone or Fortress.
Mr. Issa. OK. Thank you.
Mr. Chairman, I look forward to a second round.
Mr. Kucinich. Thank you very much.
The Chair recognizes Mr. Hodes.
Mr. Hodes. Thank you, Mr. Chairman.
Mr. Donahue, thank you for that testimony. I marvel at your
skill and the careful distinctions you made when answering
Chairman Kucinich's question in referring to the rights that
Blackstone would have under, say, the law of Delaware under
which they are organized.
It is my understanding that in significant instances the
law of Delaware also allows those registered under its laws to,
by contract, essentially disclaim various of their obligations.
For instance, in this case Blackstone has limited voting
rights and giving its investors no rights to elect board
members, according to its S-1 filing with the SEC. This is a
restriction and all of these are restrictions of rights
generally available to shareholders of what we will call normal
publicly traded companies. They have disclaimed their fiduciary
duty to investors and limited the remedies available. They have
required a super majority vote to remove general partners. They
prohibit shareholders who own more than 20 percent of
outstanding common units from voting on any matter. They limit
the unit holders rights of appraisal if Blackstone is
reorganized. And approval from Blackstone's Conflicts Committee
will be conclusive, despite Delaware law stating that this
approval will simply shift the burden to a plaintiff to show a
conflict of interest.
They go on. There are other disclaimers. I have just listed
a partial listing of the disclaimers that Blackstone makes. So
they have disclosed the multitude of ways in which they limit
the rights of those who are investing in their company.
I would like you to change baseball caps for a moment to
your far-sighted view as a regulator with vast experience and
far better than I to look forward.
Do you agree or disagree that when a company such as
Blackstone or any company sells its shares to the public, that
there is a public policy implication that kicks in to provide
or that should provide protection for the investors who are now
no longer limited to those millionaires and multi-millionaires
who are qualified investors, whether at a $1 million or $5
million level, but are not Ma and Pa, my constituents in New
Hampshire investing in various ways who do not read SEC
disclosure statements, who do not know what Blackstone is, and
who are now trying to invest? Do you think the public policy
kicks in and that we need to protect those investors?
Mr. Donahue. Protection of investors is certainly key to
the responsibilities that the Securities and Exchange
Commission has. Traditionally, for non-investment companies and
33 Act registered companies, those types of issues have been
left to State law and left to the listing exchanges for their
determinations. And the 1933 Act is a disclosure statute. It
is, for the very reason that you could state all of those what
you might characterize as non-protections, is what the 1933 Act
is about, which is to make those material disclosures to
investors so that investors can make an informed judgment about
whether or not to make those investments.
We are not in the 1933 Act context; we are in the 1940 Act
context, really merit regulators or disclosure regulators. That
is the context within which we review and allow registration
statements to go to the light.
Now, whether I have concerns about investor issues within
certain companies and about remedies that might be to
investors, of course I do.
Mr. Hodes. Understanding your role as the SEC regulator on
the disclosure requirements, do you have concerns on behalf of
the investors in the Blackstone offering?
Mr. Donahue. In the Blackstone context, I believe that the
review that was done by my brethren in the Corporate Finance
Division, that they felt that all the material disclosures were
made. They had no reason to believe that the information was
not out there for investors and their advisors to make a choice
of whether or not this is an investment that they should want
to make.
Mr. Hodes. Thank you. I see my time is up. Thank you, Mr.
Chairman.
Mr. Kucinich. The Chair will recognize Mr. Braley.
Mr. Braley. Thank you, Mr. Chairman.
Mr. Donahue, I want to talk to you a little bit about the
SEC's mandating of Blackstone's disclosure questions. Does the
SEC's judgment about whether Blackstone LP is an investment
company make that determination binding upon courts who are
interpreting the legal implications of such a determination?
Mr. Donahue. My answer to that would be no, that courts
have at times disagreed with determinations that we have made.
Mr. Braley. And, in fact, isn't it true that just last year
the 7th Circuit Court of Appeals disagreed with the SEC's
interpretation of the Investment Company Act determination?
Mr. Donahue. I assume you are referring to the National
Presto case?
Mr. Braley. Yes.
Mr. Donahue. The SEC believed that National Presto was an
investment company under both the traditional test, the
orthodox test, and the inadvertent test, and the court did
disagree with us.
Mr. Braley. Could you share with us the practical impact of
the ability of Blackstone LP to conduct its business and the
value of the units offered to the public if a court determined
that Blackstone was an investment company?
Mr. Donahue. It is a difficult question for me to answer in
my current role, but the structure they have, the way that they
operate would not be, in my judgment, practical under the 1940
Act.
Mr. Braley. Would it be possible that it would impose a
substantial obstacle to the ability of the company to conduct
its business?
Mr. Donahue. In my judgment it most likely would.
Mr. Braley. Could cause the value to fall precipitously?
Mr. Donahue. I am sorry?
Mr. Braley. Could it cause the value to fall precipitously?
Mr. Donahue. That is beyond my expertise.
Mr. Braley. All right. Did SEC staff request further
explanations from Blackstone regarding its finances, including
the partnership asset composition, in order to make a
determination whether Blackstone LP was an investment company?
Mr. Donahue. If you don't mind, I will expand a little bit
on it, because this is really an important determination. We
didn't take the registration statement, the information
contained on it, and from that just say, OK, the company says
they are not an investment company. There was much back and
forth between us trying to get more information about exactly
what the various components were, really how the assets were
being determined, and how they reached their determination that
they did not believe they were investment companies.
It is difficult to, picking up a registration statement, on
its face, to be able to tell that without getting more of the
detailed information from the company about the valuations and
a number of other things that go into that determination.
Mr. Braley. Did the SEC view the information as being
material in making its decision on the Investment Company Act?
Mr. Donahue. The information supplied to us by the
companies was critical for us to be able to determine that
their determination of the status was not accurate, yes.
Mr. Braley. And was this further information about its
asset composition disclosed to the public before the IPO became
effective?
Mr. Donahue. There were some aspects of that information
that was in the registration statement, and there was a certain
amount of that was sent to us with a request to keep it
confidential, so it was not in the registration statement.
Mr. Braley. Well, can you quantify for us, in terms of the
volume of information that was supplied that was actually made
public?
Mr. Donahue. Well, the first thing I would like to point
out is we have a registration statement that is available, but
the correspondence that goes back and forth between the
registrant and the SEC are made public unless there is an
appropriate request for confidential treatment.
Mr. Braley. When you say they are made public, in what
format are those made available to potential investors?
Mr. Donahue. The actual letters are available on the EDGAR
Web site, which is the official Web site for the SEC.
Mr. Braley. So is that something that a potential investor
could easily access as part of their own due diligence?
Mr. Donahue. That would not work well for the due diligence
that an investor might do in participating in the initial
public offering, because the initial public offering will have
already concluded by the time that correspondence is up.
Mr. Braley. Thank you. Those are all the questions I have.
Mr. Kucinich. I thank the gentleman.
The Chair recognizes Ms. Watson.
Ms. Watson. Mr. Chairman, I missed the first part of the
testimony, so I am going to kind of work backward to inform
myself, but, Mr. Donahue, in the Senate Finance hearing this
morning, Congressional Budget Director Peter Orszag testified
directly before your testimony and said that he viewed carried
interest as partly compensation for return on capital and
partly compensation for services rendered.
In his testimony, he also referred to a large body of
academic literature discussing the issue, and other witnesses
testified that carried interest differed from earnings based on
service.
Do you agree with this conclusion, with Mr. Orszag's
conclusion?
Mr. Donahue. I haven't had an opportunity to look at the
academic studies that he was referring to. I would note that
his testimony was being given, I believe, in the context of a
hearing relative to the appropriate tax treatment of carried
interest, so I don't have a view toward that.
Ms. Watson. Well, the SEC, as I understand, has determined
that Blackstone is a carried investment or carried interest and
doesn't come under the Investment Company Act. Can you comment
on that?
Mr. Donahue. I think the carried interest winds up to be an
element in our determination of whether or not the nature of
its investments, whether it meets the definition of an
investment company. The carried interest analysis goes into the
carried interest being part of the general partnership
interest. Whether the carried interest entitles the general
partner to receive income or whether it entitles the general
partner to receive it in another form, it is tied in to the
general partnership interest, I don't believe our analysis
would differ, and particularly not based on the appropriate tax
treatment of it.
Ms. Watson. Well, if Blackstone is selling publicly, there
are some things that are of concern to me, and this is an area
that I don't have a lot of expertise, but looking at it from
afar, at least if it conformed to the Investment Company Act it
would have to keep the investors well informed, it would have
to compensate or have returns on their dollars a little
differently, and also what would the protection of the
investors be like without coming under the act.
That is a concern to me. The investors cannot vote. I guess
there are no public meetings once a year. Therefore, they can
do whatever they want with management, they can raise their
salaries, they can give them huge bonuses, and they don't have
to give them full reimbursement for their investments.
So I am wondering what your view is, having them determined
as being a direct investment group and not under the act.
Mr. Donahue. I would like to start my response by saying
that I am a great fan of the Investment Company Act. I think it
provides great investments for investors. Our analysis that we
start off with recognizing those great benefits, the key
question that we first have is: is this an investment company?
If it is not, then we don't move to push it into the investment
company framework in order to get those benefits.
The threshold question is, and the charge we have gotten
from Congress, is to determine whether or not these are
investment companies. If they are, they are in the investment
company structure, for better or worse with respect to what it
is going to do with respect to how their business operates. And
if they are not, then they are not investment companies and are
not entitled to the protections of the Investment Company Act.
Ms. Watson. Well, what are you going to determine on your
way to making a decision? Can you give us a heads-up?
Mr. Donahue. On the two determinations----
Ms. Watson. Yes.
Mr. Donahue [continuing]. With respect to Fortress? We will
look at what their real business is, how they characterize
their business, what the nature of their assets are, where the
five factors that are really set up and are extraordinarily old
paced, and these are asset management companies. They happen to
be managing alternative type investments, but these are asset
management companies.
If you look at Blackstone, I believe Blackstone has over
100 different investment vehicles that they are managing. I
believe if you look at Fortress, has over 20 different
investment vehicles that it is managing. They are in the
business of managing other peoples' money, not in the business
of managing their own money. Now, their success may very well
be related to how well they do at their business of managing
other peoples' money.
Ms. Watson. Well, if you walk like a duck and you quack
like a duck, most people think you are a duck, so I would be
interested----
Mr. Donahue. Am I a duck?
Ms. Watson. I would be interested in your determination. I
will look forward to a hearing about that.
Thank you so much, Mr. Chairman. I yield back my time.
Mr. Kucinich. I thank the gentlelady.
The Chair recognizes Mr. Cannon.
Mr. Cannon. I thank you, Mr. Chairman. I apologize. We have
another hearing going on in Judiciary next door and I am a
member of that panel, so I apologize for not having been here
for your testimony prior to this.
Pursuing this investment question, how many comments did
the SEC receive regarding the classification of Blackstone as
an investment company? And how did the SEC respond to the views
of these comments?
Mr. Donahue. I am aware of two letters we received from one
entity raising questions regarding the status determination,
and also aware of a letter or two that we actually received
from Congress asking us questions relating to those
determinations. I took those seriously. If we get
correspondence coming in to us that raises questions about
whether or not we are analyzing something appropriately,
whether or not we are taking into account the right
circumstances, whether or not we might have it wrong, I take
those seriously. I want to get it right, and so we do take them
seriously.
Mr. Cannon. So did you evaluate those letters and the
claims in light of the statute and, I take it, determined that
it is not an investment company?
Mr. Donahue. When we got those, one of the first things
that I did with them was to send those letters to my
professional staff, the senior staff that actually were the
main people that were looking into the appropriate treatment of
the status of these two entities, Blackstone in particular, so
that they were aware, and told them that I, you know, want them
to take it into account and to be in a position to discuss with
me why our analysis might differ, and, if so, why we are
correct.
Mr. Cannon. So you have a statutory decision about what an
investment company is, with some exemptions. I take it these
letters didn't lead you to believe or your staff to believe
that the exemption should qualify and that this should not be
an investment company?
Mr. Donahue. It didn't lead us to believe that Blackstone
or Fortress, although I don't believe we got comments on
Fortress, that either one would require an exemption from the
SEC to qualify as not being an investment company.
Mr. Cannon. Let me just see if I understand it right. Even
if your analysis had determined that Blackstone was an
investment company, it would still likely have fallen under the
statutory exemptions to an investing company? Have I gotten
that correct?
Mr. Donahue. If the determination had been that Blackstone
met either the orthodox investment company test or the
inadvertent investment company, then they would have had to
search for a reason why those analyses wind up being
overridden. There is an analysis that they could do under a
different section that their primary business is not that and
is else, or they could apply for an exemption from the SEC from
or determination that they are not an exempted. They did not
seek a determination that they were not.
Mr. Cannon. And they didn't need to because you had already
made the determination that they are not?
Mr. Donahue. We concluded that they were not an investment
company.
Mr. Cannon. Could you explain the key distinguishing
characteristics between a mutual fund and an organization like
Blackstone LP?
Mr. Donahue. Well, simply I would start off by saying that
an investment company is in the business of managing its money,
money that comes from individual investors, and in the
investment company framework their capital structure is very
simple. You wind up generally with one class of shares, similar
rights, and the assets are valued under net asset value, and
that determines what you get for your shares if you buy them or
sell them, if it is an open-end fund. And there are a lot of
controls built around how that money can be managed, what
affiliated transactions can take place, and a lot of things.
In the case of Blackstone and in the case of Fortress, they
were not investing their money. They were managing other
peoples' money. They were more akin to the investment advisor
to a mutual fund than they were to a mutual fund. In fact,
Blackstone I believe was the investment advisor to two closed-
end funds as part of its business.
Mr. Cannon. Thank you.
Mr. Chairman, may I ask how much time I have remaining? It
seems like the clock is running very long.
Mr. Kucinich. Take another minute. Go ahead.
Mr. Cannon. Thanks. I would be happy to yield.
Mr. Kucinich. Go ahead.
Mr. Cannon. I yield that minute to Mr. Issa.
Mr. Issa. Perhaps I can bring some clarity through a
question. If we look at an architectural firm and they take on
huge jobs like building the new center here, the new visitors'
center at the Capitol, and they derive revenue from it, and
maybe even a bonus if they do a good job and it comes in under
time and under budget, which is not true of our visitors'
center, as you know--there will be no bonus earned there--but,
in fact, if that partnership chose to go public, it would be
akin to Blackstone. It drives its revenues by its management or
activities of its team, and you are investing in that team, in
the revenue stream that team earns.
Is that a fair similarity, so that we get off of the model
of are you a mutual fund or are you this other? Isn't that
really akin to, if you were evaluating that architectural firm
with all kinds of activities, including land acquisition on
behalf of clients and lots of stuff, it makes it look complex,
but ultimately you are investing in the management team; isn't
that right?
Mr. Donahue. I think that is a correct analysis. From your
description, it sounds like an operating company. I would need
to know, to make that determination--and this is, you know, the
process that we wind up going through--I would need to know
what degree of investments they might have. By way of example,
if they had considerable amount of investments that were in
investment securities, even though they are also in this other
business they may be treated as an investment company.
Mr. Issa. Right. And I will yield back, but the reason I
asked that question is you seem to have the tools to make this
evaluation of Blackstone like other companies, and these tools
have served the SEC well for many, many years, and Blackstone
is no exception; is that right?
Mr. Donahue. That is correct.
Mr. Issa. Thank you.
I yield back.
Mr. Kucinich. The Chair recognizes Mr. Tierney.
Mr. Tierney. Thank you, Mr. Chairman. I would like to just
claim my time for the purposes of yielding to Mr. Kucinich.
Mr. Kucinich. I thank the gentleman.
Mr. Donahue, in his written testimony Professor Coffee
recommends that, in light of the Blackstone LP offering, the
Securities and Exchange Commission used its influence to
pressure the New York Stock Exchange and NASDAQ to change its
listing requirement to require that publicly traded
partnerships provide the same basic corporate governance
protections for public investors that are demanded of public
corporations. Do you support this recommendation?
Mr. Donahue. I thought it was a very thoughtful analysis
and appreciation for the position that the SEC is in. I have
not had an opportunity to discuss Professor Coffee's
recommendation with the chairman or with any of the
Commissioners.
Mr. Kucinich. Thank you. Now, with your broad jurisdiction
in investor protection, as a matter of policy does the SEC have
a problem that investors in these funds are denied basic
corporate governance protection, such as being owed fiduciary
duties, an independent board, and meaningful voting rights?
Mr. Donahue. First I would like to note that the investors
are the investors in the operating company, and I think I am
not aware of any particular problems that have arisen yet with
respect to this, and I will discuss the issue with my brethren
over in corporate finance that oversee public companies and see
whether or not there have been issues in similar companies.
Mr. Kucinich. Doesn't the Securities and Exchange
Commission have a regulatory role beyond that of simply
enforcing the Securities Act and the Investment Company Act?
Mr. Donahue. Well, our primary role is in enforcing the
securities laws.
Mr. Kucinich. Do you want to elaborate on that a little
bit?
Mr. Donahue. We, as an agency, you know, should be
enforcing the Federal securities laws to the best of our
ability to protect investors. With respect to other issues, and
some issues that might arise under State laws, some remedies
that people may have contractually, that is not necessarily in
our mandate unless there is fraud taking place. We have broad
authority, but, once again, that is pursuant to the Federal
securities laws.
Mr. Kucinich. The reason why I ask that, of course, is, I
am sure you remember Chairman Levitt, who believed that it was
a proper role when he, you know, created the discussion about
the exchanges on corporate governance requirements. I am just
trying to see how the SEC currently----
Mr. Donahue. That is a distinction there, I think, and I
wasn't at the SEC when the event being referred to taking place
occurred, but, having heard the characterization of it, I would
look at that as the SEC taking a leadership role with respect
to going to others that had responsibility and could, you know,
implement changes, and suggesting that, for the protection of
investors, change might be necessary.
Mr. Kucinich. Would you agree that it is a significant
question, though, whether or not the Securities and Exchange
Commission sees itself as having a regulatory role in addition
to enforcing the Securities Act and Investment Company Act?
Mr. Donahue. I view us as protecting investors, among other
things. We have a mandate. Part of it is protecting investors.
Others is to promote capital formation and provide for orderly
markets, so we have a broad mandate and we do exercise it.
Mr. Kucinich. Thank you.
First of all, I want to thank you for your participation.
It is very helpful, a little bit more of a discussion. I know
we are going to get into some of these issues even more in
depth in the next panel, but it is important to have you here
and we want to thank you for the service that you give to our
country. Thank you very much.
Mr. Donahue. Thank you for inviting me.
Mr. Kucinich. You bet.
We are going to go to the next panel.
Mr. Issa. As the next panel is coming up, please give our
best to our former colleague, Mr. Cox, when you see him.
Mr. Donahue. I certainly will.
Mr. Kucinich. We are going to begin the second panel. I
want to welcome all of the witnesses.
It is the policy of our subcommittee and the full committee
to swear in all witnesses.
[Witnesses sworn.]
Mr. Kucinich. Let the record show that the witnesses
individually answered in the affirmative.
I would like to make the introduction of the first witness.
We will go from my left to right.
Professor Mercer Bullard is assistant professor of law at
the University of Mississippi School of Law, where he has been
since 2002. He specializes in the areas of securities and
banking regulation, corporate finance, and contracts, and he is
recognized as one of the Nation's leading advocates for mutual
fund shareholders.
In January 2000, Professor Bullard founded Fund Democracy,
a nonprofit membership organization that serves as an advocate
and information source for mutual fund shareholders and their
advisors. Fund Democracy publishes articles that address mutual
fund practices, policies and rules that may be harmful to fund
shareholders, and by lobbying legislators and regulators on
mutual fund reform issues.
Prior to founding Fund Democracy, Professor Bullard was
Assistant Chief Counsel in the Securities and Exchange
Commission's Division of Investment Management for 4 years,
where he was responsible for a wide range of matters involving
mutual funds and investment advisors.
Professor John Coffee is Adolph A. Berle professor of law
at Columbia Law School, where he has been a member of the
faculty since 1980. As one of the Nation's preeminent security
and corporate law experts, Professor Coffee has served as a
member of many influential financial advisory boards and
commissions, including the New York Stock Exchange, NASDAQ, and
the Securities and Exchange Commission. He has testified
numerous times before congressional committees. He has co-
authored a number of textbooks on securities and corporate law,
and the National Law Journal has named him 1 of the 100 most
influential lawyers in the United States.
Next, Mr. Joseph Borg is president of the North American
Security Administrators Association, which represents 67 State,
provincial, and territorial securities administrators. He has
been a Director of the Alabama Securities Commission since
1994.
The NASAA member agencies work to protect consumers who
purchase securities or investment advice, and regulate a wide
variety of issuers and intermediaries who sell securities to
the public.
Prior to his career in public service, Mr. Borg was in-
house corporate counsel to First Alabama Bank, practiced in law
firms in Montgomery, AL, and New York City. He also served as
an adjunct professor of law at Faulkner University Jones School
of Law.
Finally on the panel, Mr. Peter J. Tanous. Mr. Tanous is
president and CEO of Lynx Investment Advisory, LLC, which he
founded in 1992. Lynx Investment Advisory is an independent
investment consulting firm specializing in asset allocation,
risk management, and customized portfolio design. Lynx has over
$1.4 billion under advisement, and on behalf of both nonprofit
and for-profit institutions and affluent individuals worldwide.
Previously Mr. Tanous was executive vice president of Bank
Audi in New York City, Chairman of Petra Capital Corp., and
first vice president and international regional director with
Smith Barney.
Mr. Tanous is the author of Investment Gurus: the Wealth
Equation, and his latest book, Investment Visionaries.
I want to thank all the members of this panel for their
presence, their participation.
Let us proceed with Professor Bullard.
I also want to welcome Mr. Danny Davis and also Mr. Bilbray
to our committee. Thank you.
Let us proceed. Thank you. You may proceed.
STATEMENTS OF MERCER E. BULLARD, UNIVERSITY OF MISSISSIPPI LAW
SCHOOL; JOHN C. COFFEE, JR., COLUMBIA LAW SCHOOL; JOSEPH P.
BORG, PRESIDENT OF THE BOARD OF DIRECTORS OF THE NORTH AMERICAN
SECURITIES ADMINISTRATORS ASSOCIATION; AND PETER J. TANOUS,
PRESIDENT AND CEO, LYNX INVESTMENT ADVISORY, LLC
STATEMENT OF MERCER E. BULLARD
Mr. Bullard. Chairman Kucinich, members of the
subcommittee, thank you for the opportunity to appear today
before you to discuss the public offering of interest and hedge
fund managers. It is an honor and a privilege to appear before
this subcommittee today.
The question for today's hearing, Should investors be
exposed to the risks of hedge funds, is answered by current law
in the negative. Only sophisticated persons are permitted to
invest in hedge funds. I believe that the answer should be the
same for hedge fund managers that are the functional equivalent
of hedge funds. There appears to be substantial agreement on
this point. Virtually every commentator on the Blackstone IPO
had described the firm's future prospects as depending directly
on the performance of its funds. The financial press has
suggested that the Blackstone offering, for example, provides a
way for small investors to access the previously forbidden
world of hedge funds.
It is worth noting that no one views the future prospects
of pure asset managers such as T. Rowe Price as depending
directly on the performance of their funds, and firms such as
T. Rowe Price accordingly have traded at a tiny fraction of
their assets under management, whereas hedge fund managers have
traded at 20 or 30 times that fraction.
The markets recognize that hedge fund managers are the
economic equivalent of hedge funds, and we should respect the
market's judgment. The market's judgment is confirmed by the
structure of hedge fund managers, as illustrated by Blackstone.
A majority of Blackstone's assets are investment
securities. Of its $7.2 billion in assets on its March 31st
balance sheet, $5.2 billion are investments in its funds and
funds portfolio companies, another $4.1 billion are carried
interest, which substantially exceeds 50 percent of its total
assets. I note that includes a denominator that includes assets
that have virtually nothing to do with any business activity,
such as its goodwill, deferred tax assets, and cash. If you
eliminate those assets, virtually all of the meaningful assets
held by Blackstone are investment securities.
There is disagreement as to whether Blackstone's carried
interest or investment securities under the Investment Company
Act. I am not aware of any disagreement that carried interest
are the economic equivalent of a leveraged bet on Blackstone's
funds. Someone suggested that carried interest should be viewed
as compensation. Professor Coffee, for example, suggests that
carried interest are more like compensation on the ground that
investors and hedge fund manager do not share the funds'
``downside'' because they will ``simply not receive their share
of the nonexistent profits from that fund.''
I must respectfully disagree. Blackstone's $4.1 billion in
carried interest are exactly what investors in Blackstone are
buying, and that figure is based on the current value of those
carried interests. If Blackstone's funds take a turn for the
worse, Blackstone's investors will lose billions of dollars.
The severity of those losses will actually exceed
proportionately the decline in the funds because a carried
interest skims profits off the top of a fund's performance. A
slight decline in a fund's annualized performance has a
multiplier effect on the value of a carried interest.
I would refer you to this morning's hearing on the Senate
side, during which this point was made repeatedly by every one
of the persons testifying at that hearing.
Professor Coffee's position is correct as to the Blackstone
manager who sees a carried interest that started as a zero
value and goes up and returns to zero, but it is incorrect as
to the purchaser of a carried interest in the middle of a
fund's life. When a Blackstone manager sells his carried
interest at that point, he is effectively cashing out his part
of the carried interest before its value has been realized and
leaving public investors holding the bag in the event of the
fund's performance declining.
Professor Coffee further suggests that reading the ICA to
include carried interest in the definition of investment
security reads the definition too broadly because it would mean
that every business' ``actively managed subsidiary would thus
become an investment security. At this point, the ICA applies
to everything.''
That would be a fair observation but for the fact that the
securities issued by subsidiaries would be investment
securities under the Investment Company Act if Congress had not
specifically excluded from the definition. The ICA defines
investment security to exclude all securities, to include all
securities except securities issued by majority-owned
subsidiaries.
I mentioned Professor Coffee's comments not only out of my
high regard for his opinions on securities law issues, but also
because I believe that we are substantially in agreement on the
critical policy question for this subcommittee. Although I have
stated that public investors should not be allowed to assume
the risk of hedge funds and Professor Coffee argues that they
should, he uses risk in an economic sense and I use it in a
broader functional sense. If risk were to include the risk of
inadequate corporate governance, which I include in the concept
of risk, Professor Coffee and many others would agree that
public investors should not be exposed to such risk.
Professor Coffee describes Blackstone's corporate
governance as pathological and recommends reforms notably that
would apply if Blackstone were treated as an investment company
under the Investment Company Act.
In conclusion, the ICA's regulatory framework and exemptive
provisions are ideally suited to address the regulatory
shortcomings that have been exposed by the Blackstone offering.
It is unfortunate that the SEC has decided not to take
advantage of this efficient, proven approach to regulation, and
I strongly recommend that Congress, assuming continued SEC
inaction, take steps to ensure the appropriate regulation of
hedge fund managers.
Thank you very much.
[The prepared statement of Mr. Bullard follows:]
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Mr. Kucinich. I thank the gentleman.
Professor Coffee, you may proceed.
STATEMENT OF JOHN C. COFFEE, JR.
Mr. Coffee. Thank you, Chairman and members of the
committee, for inviting me to be here.
My message is simple. This is the Oversight Committee, and
the Blackstone approach to going public needs a great deal of
oversight. I am not recommending legislation, and I, in my
comments, urge the committee and regulators to always use the
least drastic means available to realize the regulatory
objective. I also happen to be a supporter. I believe that
private equity funds and hedge funds are among the most
successful, dynamic performers in our financial services
industry, but I do think there is a problem. The Blackstone
offering has established a template for future offerings by
managers of private equity funds and hedge funds. Already
others are lining up and there is a race to rush to the window
before it closes.
Unfortunately, that template has three elements that
represent the worst imaginable corporate governance. As has
already been pointed out, there are no meaningful voting
rights. Beyond that, the founders of the firm have the right to
remove any of the directors at any time if they act together
jointly.
Second, there is no independent board. Indeed, there is
neither a nominating committee nor a compensation committee
that has any independence. That to me is totally against the
trend which the business community, itself, has come to and
accepted that independent directors are necessary for publicly
held investments because that is where the ultimate protection
and the legitimacy enterprise comes from, oversight by
independent directors.
Finally, there is no meaningful fiduciary duties owed to
the investors because the partnership agreement has exploited
all the potential under Delaware law to cancel the normal
fiduciary duties. That is because Delaware law regards a
partnership agreement as really a private contract among a
small, limited number of people, not a mechanism by which
thousands of investors are asked to trust other people's money,
in effect, to financial managers who do face significant
conflicts of interest.
Thus, voiceless, voteless, and stripped of legal remedies,
Blackstone's investors must remain passive. There is not even
the usual possibility of a control contest, because no one can
vote more than 20 percent.
Now, how did this unique and I have said pathological
governance structure arise? You can attribute it to one of two
things: one, that the company is deemed to be exempt from the
Investment Company Act. I would like to get this committee's
attention beyond the Investment Company Act. I think we are a
little too obsessed with just the Investment Company Act. The
problem here is basically one of corporate governance. There is
little transparency and no accountability under the governance
structure that Blackstone has put in place and that others are
rushing to copy.
The other reason why there is this pathological structure
is that Blackstone was not subject to the usual corporate
governance standards required by the New York Stock Exchange
and NASDAQ because it went public as a limited partnership, not
as a corporation. While the critics have all focused on the
Investment Company Act, I think the Investment Company Act,
frankly, is a remedy that can sometimes be worse than the
disease when it is applied to those entities that are at least
at the margin of its possible coverage.
You could make this an investment company and then exempt
Blackstone from most of the rules under the Investment Company
Act. That would work. But I think it is much simpler and more
direct to focus on what we want to achieve. I believe what we
want to achieve is greater accountability, greater
transparency, and that can be done by simpler ways than
imposing the investment company straightjacket on this
particular entity.
Now, how do we get to this goal of greater accountability
and greater transparency? I think the simple problem here is
that partnerships are never subjected to normal corporate
governance standards because in the past partnerships very
seldom went public. When we have seen publicly held
partnerships, they were used basically to hold passive pools of
investments--real estate, oil and gas, timber. There aren't
serious corporate governance problems there. But Blackstone is
an operating company that is basically restructuring companies,
not holding a passive pool of investments; therefore, what
should we do?
Well, besides State law the other mechanism by which
corporate governance standards are imposed on publicly listed
companies are the rules of the stock exchanges, both New York
and NASDAQ today. The New York Stock Exchange since its
inception has had minimum corporate governance standards, but
it has had no reason to apply them to partnerships because they
were a tiny aspect, probably no more than 1 or 2 percent of all
listed companies.
The New York Stock Exchange, under influence of Congress,
under the oversight of Congress, did move to adopt strong
independence standards requiring an independent board, and it
is a majority independent board; entirely independent
nominating, audit, and compensation committees; and a lead
director and a process for annual evaluation of the chief
executive officer. All of that is in the interest of
investigators. The business community does not resist this.
The typical American public corporation today has 10.4
directors and over 8 of them are independent. That is not the
law; that is the norms established by the business community
and respected by them. But a partnership is exempt from that.
This didn't arise by any conscious decision to exempt
partnerships; it arose by the unconscious design, the
unconscious fact that there was no need to develop governance
rules for partnerships. Today there is. I think this is a
process that needs oversight.
I think in the past we have seen the SEC, under Chairman
Arthur Levitt, go to the exchanges and ask them to upgrade
their governance standards. He did that with respect to the
one-share/one-vote rules, where the court struck down the
mandatory rule but Chairman Levitt was able, through diplomacy,
to convince the exchanges to adopt minimum rules to protect
shareholders' voting rights.
I think the exchanges should be invited before this
committee to explain whether they are satisfied with the idea
that shareholders would have no independent voting rights; no
right to a majority of independent directors; no compensation,
audit, or nominating committee that was independent; and no
other rights that are traditionally associated with publicly
held companies.
I think that is in the long-term national interest because
the market works best when we have the oversight of independent
directors. That is the least drastic means, and I think we
should move in the direction of trying to implement that
particular remedy.
Thank you.
[The prepared statement of Mr. Coffee, Jr., follows:]
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Mr. Kucinich. I want to say to Professor Coffee I think
that you have made a worthwhile suggestion here to the
committee with respect to asking the New York Stock Exchange
and NASDAQ questions such as the ones that you have raised.
Thank you, sir.
Mr. Borg.
STATEMENT OF JOSEPH P. BORG
Mr. Borg. Thank you. Chairman Kucinich, members of the
subcommittee, I appreciate the opportunity to testify today on
an issue of importance to retail investors.
State securities regulators have a special appreciation for
the plight of everyday investors who are confronted with a
bewildering array of new and complex investment products. We
are the only securities regulators who interact with and
advocate for individual investors on a personal basis each and
every day. In short, we are uniquely qualified to address the
potential impact of making alternative investments such as
hedge funds widely available to the average individual
investor.
My remarks should not suggest to you that I believe the
retail investing public is unable to properly evaluate
investments, nor am I suggesting that regulators should adopt a
paternalistic approach and withhold alternative investments
from the average retail investor.
What I do suggest to you today is the following: new
investments with highly complex structures, opaque investment
strategies, and dubious profitability have arrived on Main
Street. Precisely because of this trend, the investigator
protections afforded by statutes like the Investment Company
Act are more important than ever.
Due to a nearly complete lack of transparency, the level of
individual and systemic risk attached to these instruments
remains unknown to the individual investor. Their fee
structures and lack of full disclosures obscure real returns.
The structure of these new instruments places investors in
a vulnerable position subject to the whims of controlling
persons and literally without recourse. In light of the
complexity and uncertainty surrounding these instruments,
allowing them to be offered to the public without appropriate
regulatory protections poses serious risks to the investors.
As a threshold matter, we believe that public offerings by
private equity firms or hedge funds must provide full
transparency and investor rights and protections. More
particularly, we believe that private equity firms engaging in
public offerings, when structured as Blackstone is, should be
subject to the requirements of the Investment Company Act of
1940.
While the Securities Acts of 1933 and the Securities and
Exchange Commission Act of 1934 protected investors from
potential abuse by corporate managers and financial
intermediaries, they could not adequately protect investors
from abuses by organizers of pooled instrument vehicles.
Congress enacted the ICA to impose additional layers of
protection for investors, including independent boards,
fiduciary duties, shareholder rights, heightened disclosures,
restrictions on permissible investments, and even limits on
fees and loads.
Offerings such as the Blackstone IPO circumvent the
governance protections that the ICA mandates, even though it is
no longer a private investment company. For example, under the
ICA a fund must have independent directors who represent the
interests of public investors. Additionally, investors are
protected by the fiduciary duty that attaches to officers and
directors. Neither is the case with Blackstone.
We must remember that the securities laws favor substance
over form and disdain structures whose only purpose is to evade
their reach. In reality, both pre-and post-IPO, Blackstone
functions as an investment company that earns its income
through investments. From an investor protection standpoint, we
are puzzled by the exclusion Blackstone enjoys from the
safeguards mandated under the ICA.
The SEC has viewed this type of structure broadly and
flexibly since the enactment of ICA. My written testimony cites
a number of legal opinions where the SEC recognized that even
funds engaged to a significant degree in ``special
situations,'' as is Blackstone, qualify as investment
companies. For decades, the SEC has been guided by ``In re:
Tonopah Mining Company,'' which set forth five factors to
determine whether a company was operating as an investment
company: the company's history, its public representations, the
activities of its officers and directors, the nature of its
assets, and the sources of its income, all of which serve as a
proxy for what a reasonable investor would believe to be an
investment company.
Tonopah identified the most important factor as whether the
nature of the assets and income of the company was such as to
lead investors to believe that the principle activity of the
company was trading and investing in securities. We believe
that Blackstone meets this test. The Blackstone structure, now
being copied by others seeking to ``go retail'' appeals to mask
the nature of the assets and income of the company in order to
avoid the strictures of the ICA and to allow its continued
operation as a de facto private company. Neither goal serves
the interest of investors or marketplace.
The new entities attempted to escape the conclusion that
they are investing companies through a purely structural
maneuver: adding a new layer in its corporate form, Blackstone
LP, and then selling units in Blackstone LP to the public. But
measured by the true nature of its activities and its
investment holdings, the Blackstone structured entities should
be regulated as investment companies.
The prospectus makes it clear to investors that they will
share in the rewards and bear the risks of Blackstone's
investment activities. The point is further reinforced through
the identification of the carried interest as a significant
source of potential gain for investors.
Presumably, Blackstone would suggest that their offering
poses no undue threat to investors because, while it may be
risky, those risks are disclosed. The public policy issue is:
how much risk, even when disclosed, should be transferred to
the general public? In a perfect world a careful financial
advisor will say Blackstone type entities are too risky, too
opaque, too conflicted, so we won't invest. However, the real
world operates much differently. Securities salespersons sell
whatever their firms tell them to sell. They are not likely to
delve deeply into disclosed risks with the customer sitting
across the kitchen table.
The IPO disclosures come dangerously close to an
affirmative statement by Blackstone that it will conduct its
business in whatever way it chooses, and that the investors
must waive any rights or remedies for such conduct. It is
precisely for these reasons that Congress enacted the ICA, not
just to ensure disclosure, but to impose affirmative duties on
such companies and to delineate boundaries in the operation of
these inherently risky enterprises.
In the Blackstone IPO, which apparently now will be
followed by KKR, Och-Ziff Capital, and others, a fundamental
purpose of the ICA is imperiled. That purpose is the protection
of the investing public from the potential risks of investment
pools. When private speculators turn to the public markets for
capital, what Justice Brandeis called ``other people's money,''
they cannot continue to operate as if they were still a private
concern.
In conclusion, I want to emphasize that NASAA does not
object to access to alternative investigations by retail
investors so long as they are accompanied by all appropriate
and necessary investor protections, rights, and remedies. This
can only be accomplished by ensuring such investments are
offered pursuant to the appropriate act.
Your constituents, America's retail investors, are not
accustomed to the realities of alternative investments,
portfolios of illiquid securities, the use of substantial
leverage, concentration of investments, and excessive
compensation arrangements detrimental to their interest.
Congress sought to eliminate these elements of alternative
investments from the public marketplace. Surely, your and our
constituents are still deserving of the protections so wisely
provided to them.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Borg follows:]
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Mr. Kucinich. Thank you very much, Mr. Borg.
Mr. Tanous.
STATEMENT OF PETER J. TANOUS
Mr. Tanous. Thank you, Chairman Kucinich and Ranking Member
Issa, for allowing me to appear before you today.
Let me make several points relative to the discussion
today. The first was made by Congressman Issa earlier, which is
the difference between private equity firms and hedge funds.
They are in very different businesses, and I won't belabor that
point. They have two things in common. One is that they both
charge very high fees, and the other is that their liquidity is
very limited. In the case of private equity firms, you are
basically investing for a number of years.
Now, what are the risks in owning shares of Blackstone,
because that is on the table today? We shouldn't confuse the
risk of owning the Blackstone management company, we should
call it, with the risk of investing in Blackstone funds. They
are very different. The people who bought the Blackstone shares
are basically buying into a stream of income from the fees that
Blackstone earns. That is arguably not very different from the
risk any investor takes when an investor buys a company that is
competing in the marketplace and is subject to whatever the
competitive factors are.
Now, it also has been pointed out that the unit
shareholders of Blackstone do not have the same rights as most
stockholders do. I don't particularly like that, but the fact
is that when an investor decides to invest in it, the investor
knows or should know what those limitations are.
I might also point out that there are other examples, such
as in the newspaper industry where you have two classes of
stocks, and most of the investors have very limited rights with
respect to electing the board and other rights.
Are hedge funds safe for the average investor? There is a
wide gamut of hedge fund activities and philosophies, and,
frankly, they run from very safe to very risky. In our
business, though, because they are not at all transparent, we
do not want our investors, even very wealthy ones, to take the
risk of buying a single hedge fund. We all remember last year
the case of Amaranth. This is a case of a hedge fund that was
very highly regarded, a lot of very smart people had money with
them, and they bragged about how good their controls were, and
yet a 32-year-old trader made a big bet on natural gas and lost
$5 billion in 1 week and the fund subsequently folded.
For those who are interested in hedge funds, small or large
investors, we think they should use funds of funds where the
risk is spread out over 20, 30, or 50 separate hedge funds.
Finally, should private equity firms and hedge funds be
regulated by the SEC, which seems to be the major topic today?
The SEC was created to protect investors, and the American
capital systems are the envy of the world as a result of the
honesty and integrity of our systems. My firm is registered
with the SEC. We file a form ADV once a year, sometimes even
more frequently, and we have to disclose lots of things in that
form. We have to disclose our board of directors, our
shareholders, the nature of our clients, and what not.
Now, I heard--forgive me for characterizing it this way--
the legal mumbo-jumbo about why Blackstone is not subject to
SEC rules, and I would rather apply a simpler test that was
alluded to earlier in this hearing. If it looks like a duck and
acts like a duck and quacks like a duck, it is a duck. I
suggest that, to me, Fortress and Blackstone are investment
ducks, and if my firm is regulated by the SEC I can think of a
lot of reasons why they should be, as well.
Thank you, Mr. Chairman.
[The prepared statement of Mr. Tanous follows:]
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Mr. Kucinich. I thank the gentleman.
We are going to go to questions from members of the panel.
Mr. Tierney, would you like to go first?
Mr. Tierney. Well, I think I fall in line with most of the
public here. I am not sure that I understand all that I ought
to understand about what seems to be a complex issue, but I
look at it more from the standard of somebody that has worked
all their life and put money into a pension fund, to have those
pension fund managers turn around and invest in something like
a Blackstone on that. So I guess my question would be: what
protections do we have under the current system for those
individuals? And what protections ought we have for them?
Professor, we will start with you and just go left to
right.
Mr. Coffee. I think right now the only protection that a
pension fund manager investing in Blackstone, the hedge fund
manager, not the Blackstone funds, have would be rule 10(b)(5)
in the law of fraud. I am not alleging in any way that there is
any fraud, but you don't have the usual mechanisms. You don't
get to vote. You don't get your right to information. You don't
have independent directors owing you fiduciary duties. And
there is no prospect that if this management is poor some other
management will come in and buy them out and have a control
fight. None of that can happen under the way this has been
designed, and I think that is a very poor precedent for the
future.
My focus is not on Blackstone, but we are opening up a
possibility of a whole new asset class, which could be over
$100 billion in a few months or years, composed of entities
that are in a business that is full of conflicts of interest
and there is not any of the traditional mechanisms of corporate
accountability applicable to them.
Mr. Bullard. I would add to that I see your question in the
context of it being publicly offered. My view is that if the
pension fund were investing in a Blackstone, that by itself
Blackstone should be able to do anything it wants and I
wouldn't object to any of the provisions that Professor Coffee
has mentioned.
I think he is meaning in the context of a public offering,
because no one questions it in today's context. A pension fund
can invest. It can agree contractually to all of those onerous
pathological provisions and I don't think anyone on this table
objects to that. What is objectionable is when that vehicle
becomes available in the public market.
Mr. Coffee. I misunderstood your question. He has corrected
me. I thought you were asking about investment in the public.
Mr. Tierney. I probably wasn't as clear as I should be. As
I said, I don't think I understand it as fully as I should.
What is the harm to Blackstone if they go out and are treated
as an investment company? What is the deal to them? I am
telling you, from somebody on the other side that doesn't
completely understand all of it, this thing just smells to high
heaven. I am looking out there and saying, you know what, this
is distasteful. This reminds me of a lot of things that have
happened in our history where the small guy gets tucked and
somebody else walks away with all the dough. They are taking
care of themselves, as the gentleman at the end said, with a
lot of mumbo-jumbo, and they are off and running.
So why don't we just regulate them and make them do the
things we reasonably make other people do? What is the harm?
Mr. Coffee. If you were to subject Blackstone to the
Investment Company Act, much of what they currently do could
not be done without a new form of exemption. For example, that
would include that there is a prohibition on incentive fees and
that you right now are receiving very high incentive fees based
on percentage of profits. That is regulated by a series of
rules that treat mutual funds very differently than hedge
funds, and they are very different animals. They are not that
similar at all in terms of their behavior.
There are restrictions on leverage, and it is the case that
a true investment company can't have more than approximately 15
percent of its assets in illiquid investments. All of what
Blackstone owns is illiquid investments, so that they would
have to have a very different portfolio. There could be
exemptions given. I fully agree the SEC could call it an
investment company and take 80 percent of it back, but that
seems to me going up the hill and back down the hill and
accomplishing very little along the way.
My colleague here differs.
Mr. Bullard. Well, I agree that they simply would not be
able to function if they were subject to all the requirements
of the Investment Company Act. That being said, I think I would
go further than Professor Coffee in pointing out that the
exemptive process is a longstanding tradition of the SEC. It
has created numerous entities and allowed them to be publicly
offered, subject to carefully tailored exemptions. For example,
asset-backed securities have a virtually complete exemption
from the act. Exchange traded funds exist only because of an
exemption from the act. Even more, the multi-class funds with
their A, B, and C shares are prohibited by the act. They exist
because of an exemption. The 12(b)(1) fees are prohibited by
the act. They exist only because of an exemption. Money market
funds are prohibited by the act. The only reason that we have
only $2 trillion in money market funds is the SEC exemptive
authority, and that is a much more efficient way to regulate
them than to go to the exchanges to obtain some kind of limited
governance reform.
Mr. Tierney. Mr. Tanous, I sympathize with what you were
saying. If your firm has to register, why don't they? Would you
put them under the Investment Act, or would you do some of the
other more novel approaches of Professor Coffee?
Mr. Tanous. Mr. Tierney, I would put them under the
Investment Act, but make the exceptions that were enunciated
here. That seems to be the best way to do it. The idea of
putting them under the Investment Act and saying that now they
are going to have to comply with all of the provisions that
were written in 1940 obviously doesn't make much sense. But
there is a simpler way and more practical way to do this, but
they should be regulated.
Mr. Tierney. Absolutely.
Thank you all very, very much.
Mr. Kucinich. Mr. Cannon.
Mr. Cannon. Thank you again, Mr. Chairman. I apologize for
going back and forth. We have a high level panel on clemency
going on in the Judiciary Committee, which is just next door,
and so Mr. Issa and I are both on both of these committees and
are going back and forth. So, again, I apologize for the
erratic presence.
I do actually have some questions that I would like to go
into with this panel.
Mr. Tanous, could you explain for the committee the concept
of investing in funds of hedge funds and what this type of
investing does to insulate--I am sorry, we don't want to ask
that question.
Mr. Tanous. I would be happy to answer.
Mr. Cannon. What I would rather ask is this: would you
agree that organizations like Blackstone are nothing like Long-
Term Capital Management, and therefore comparisons between the
two are flawed?
Mr. Tanous. Yes. I don't think they are anything like Long-
Term Capital Management. The Long-Term Capital Management blow-
up was largely an issue of very high leverage, and that, to my
knowledge, is not at all the case with respect to Blackstone
and the activities that they do.
Mr. Cannon. And would you describe their activities, just
in comparison?
Mr. Tanous. Say that again?
Mr. Cannon. Would you describe Blackstone's activities?
Mr. Tanous. I am not an expert on Blackstone, but basically
they have a number of different activities. The one that they
are best known for is private equity. Essentially, they will
buy a company out, improve it, sell it back on the market at a
higher price, and make money for their fundholders and
themselves.
Mr. Cannon. Thank you.
Now if I can shift to Mr. Borg--and maybe you can come back
on this Mr. Tanous--the idea that you have private equity and
that there is some risk involved--of course, with any
investment you have some risk, but you also have these large
investment funds, retirement funds. Those are run, Mr. Borg, by
professionals, and, in fact, CALPERS has, like, $21 billion
that is invested just in their investment portfolio in private
equity, the California State Teachers Retirement System has $10
billion in private equity, and apparently the Ohio Public
Employees Retirement System has $600 million invested in
private equity. These are among the most sophisticated managers
of money on earth. No private individual could spend the kind
of time and focus. Do we need to be worried about those people
making decisions that are inappropriate, where the risk would
be inconsistent with the return?
Mr. Borg. As with any pension fund, as an institutional
investor certainly they are different than the retail market
that I was addressing. We are talking about the Mom and Pops in
the kitchen trading stocks on the kitchen table. The pension
funds, with their managerial experience, would qualify for even
having Blackstone-like entities come and talk to them on a one-
to-one basis and talk about details that a retail investor will
never hear about. That is the first thing.
Are there dangers with respect to the pension funds? Sure.
There are a lot of pension funds that are under water because
of changes in the market conditions, especially since the crash
of 2000-2001. The bottom line, though, is retail investors who
won't even know what an illiquid pool of investment is, the
pension funds, with their expertise, can make a more informed
judgment as to what their risk factors are. Plus, most pension
funds--and I can speak for the pension fund that I am familiar
with, which of course would be the State of Alabama--there are
certain criteria where they cannot go over a certain amount of
risk, as well.
That is vastly different than asking somebody to take their
retirement fund from their job and all of the sudden they have
$30,000 or $50,000 in Blackstone with very little protections
at all. In fact, even the big pension funds, the bigger they
are the more they are going to be listened to, even if they
don't have protections, to some extent, because they are a
force to be reckoned with, not the retail investors.
Mr. Cannon. Professor Coffee, would you like to comment on
that?
Mr. Coffee. I think I agree very much with what Joe Borg
has just said. In the world of the private pension fund, the
governance is really by contract. The pension fund sits down
and contracts with the hedge fund manager and maybe will agree
that you have the right to redeem after 6 months, 1 year. You
have all kinds of provisions that you put in by contract. That
is not feasible when we move into the world of public markets
where little investors can't contract with the manager and
where the small retail investor doesn't know to diversify.
Intelligent pension funds are going to be diversified among
a variety of different hedge fund and similar investments. The
retail investor unfortunately chronically under-diversifies.
Mr. Cannon. I might point out that is probably less the
case since Enron collapsed and people are aware of the
possibility, but over time it is probably clearly the case.
Thank you, Mr. Chairman. I yield back. Do we have a vote?
Mr. Kucinich. We do. I am going to try to get my questions.
How much time is left on that vote? We are going to try to do
this.
I would like the members of the panel, in particular
starting with Mr. Bullard and then Professor Coffee, assuming
that Blackstone were regulated under the Investment Company
Act, from what provisions would you grant or not grant
exemptive relief?
Mr. Bullard. I would probably subject them to virtually all
of the corporate governance provisions. They would have an
independent board. They would have to get shareholder approval
for various fee issues, which would in this context be
essentially executive compensation. I think on that point I
would probably agree with Professor Coffee.
Where I would disagree is I think that one thing the
Investment Company Act provides that the exchanges cannot do,
which is to limit affiliated transactions and provide that they
only occur under certain circumstances, and the SEC has a long
history of granting exemptions to business development
companies where they have managed the problem of co-investments
and other affiliated transactions for that purpose.
Other than those two major categories, I think that
virtually all of the other requirements of the Investment
Company Act would be handled through better disclosure and some
standardizing of the disclosure regarding volatility and risk.
Mr. Kucinich. Professor Coffee.
Mr. Coffee. To the extent that there is a debate or a
dialog between Professor Bullard and I, it is really a debate
about whether you apply the statute and then grant exemptions
for 80 or 85 percent of it, because that is the order of
magnitude we are talking about in terms of exemptions, or,
alternatively, we say the simpler, more direct approach is to
focus on that 15 percent of the statute that we think is
relevant today and not make it applicable and then repeal it,
but rather say what we want is better independent boards, we
want better voting rights, we want fiduciary duties to apply,
and I agree we want related party transaction to be restricted.
But I do think that the SEC using its disclosure options can
put a very strong oversight over affiliated transactions, and I
don't think that really is the problem with Blackstone.
Mr. Kucinich. Mr. Borg, did you want to weigh in on that?
Mr. Borg. Very quickly. I think that there is a 1990 case--
and I am going to defer to the professors--that says the SEC
cannot apply those listing standards. I may be wrong on that.
Mr. Coffee. You are talking about the Business Roundtable
case----
Mr. Borg. Yes.
Mr. Coffee [continuing]. Which I do discuss. And I think
this has to be done by diplomacy, but that is the least drastic
means.
Mr. Borg. I think this actually opens up the SEC to a
possible lawsuit if they try and do that, even by a separate
agreement, if there is a case law that says you can't do that.
But I agree in general with the idea that those are the
protections that need to be imposed. I only see at this point
the existing law as the ICA as the one method available at this
time.
Mr. Kucinich. Mr. Tanous, did you want to add anything?
Mr. Tanous. My only concern, Mr. Chairman, and perhaps one
of the other panelists could address it if you want them to,
but I worry about the slippery slope aspect of mandating or
even legislating how the voting is going to take place in some
of these firms, because the issue of the two classes of stocks
in a number of corporations comes to mind where you have class
A stock with one vote and class B stock with ten. Where do you
draw the line in terms of voters' rights and prerogatives?
Mr. Kucinich. Thank you. I just have one quick question. I
would ask Professor Coffee to respond. If the exchanges were to
adopt new rules for hedge fund managers, what should those
rules be?
Mr. Coffee. I think the first thing would be that there
would be a majority independent board, or perhaps it could even
be as high as the Investment Company Act may require in the
future, and I think that there should be independent
nominating, audit, and compensation committees.
As to affiliated party transactions, both the exchanges and
the SEC could require periodic disclosure that I think would
focus on the danger of affiliated party transactions.
Mr. Kucinich. I want to thank the panel. We have a vote on
right now that I am going to have to go to, but I think we have
covered the territory substantively in a relatively short
amount of time.
This has been a hearing of the Domestic Policy Subcommittee
of the Oversight and Government Reform Committee. The topic of
today's hearings has been: After Blackstone, Should small
Investors Be Exposed to Risks of Hedge Funds? We have had a
representative of the Securities and Exchange Commission
testify, as well as experts in securities issues that relate to
this pertinent matter.
I want to thank very much all of the people who testified
today.
This committee stands adjourned.
[Whereupon, at 3:07 p.m., the subcommittee was adjourned.]
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