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Thursday, May 22, 2003
U.S. House of Representatives,
Subcommittee on Capital Markets, Insurance,
And Government Sponsored Enterprises
Committee on Financial Services,
Washington, D.C.

    The subcommittee met, pursuant to call, at 10:06 a.m., in Room 2128, Rayburn House Office Building, Hon. Richard Baker [Chairman of the subcommittee] presiding.

    Present: Representatives Baker, Ose, Gillmor, Bachus, Oxley (ex officio), Kelly, Fossella, Biggert, Toomey, Hart, Tiberi, Kanjorski, Inslee, Capuano, Ford, Clay, Matheson, Miller, Emanuel and Scott.
    Chairman BAKER. [Presiding.] This meeting of the Capital Markets Subcommittee will come to order.
This morning, we are here to examine not a new market mechanism, but one which has exhibited extraordinary growth over recent years, the hedge fund. To start with, there is not even a clear definition of what constitutes a hedge fund. Although hedge funds perform amazingly well, they are not necessarily linked to overall market performance. Hedge funds have demonstrated an ability to generate positive cash flow in a down or up market, which is a good thing. Hedge funds have also generated significant liquidity and helped to be a counterbalance to the risk prevalent in ordinary market functions, which is a good thing.
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    So our purpose here today is not to condemn the hedge fund concept, but merely to continue the committee's ongoing examination of all aspects of market function, which began almost three years ago. There is some expressed concern as innovation proceeds that the fund of funds becomes a methodology for the retailization of hedge fund risk, which certainly leads us to examine suitability requirements and the necessary transparency of disclosure of the risk undertaken by hedge funds so that even the sophisticated investor may properly examine the risk they are assuming with their investment. Beyond the initial disclosures made at the time of investment decisions, it is apparent to me that a continuing disclosure regime would also be advisable, given the nature of the hedge fund's changing its risk profile. Certainly, there should be examination of the standards for the management of the hedge fund. With the extraordinary growth not only in the nominal dollar amount, but in the numbers of hedge funds, as best we can determine what they are, there is certainly an increased level of anxiety about the adequacy of management not only in disclosure, but in day-to-day governance of the risk assumed by their operation.
    We also need to examine the current regulatory requirements for registration. Since the manager of a single hedge fund is not required under current rule to become a registered compliant entity with the SEC, therefore the manager of up to 14 hedge funds perhaps could not be subject to SEC oversight and examination, and whether that regime is appropriate in today's environment.
    Having listed a number of concerns, certainly the function of hedge funds in today's market is a positive addition. We should do nothing that would bring, or at least in my opinion, hedge funds under day to day governmental regulation where we have someone from the SEC sitting on the board of every hedge fund. But I do believe it is appropriate to examine the risk they potentially could present, given their enormity, to systemic risk developments, and to further examine whether the individual investor truly understands the risks they may be assuming and whether the continued explosion of funds and the potential retailization brings those into the market who really should not be there.
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    I certainly appreciate those who will participate in the hearing this morning. I have read Chairman Donaldson's statement. I find it most helpful to the committee, and look forward to hearing from other witnesses who will come before us on the second panel.
    At this time, I recognize Mr. Kanjorski for any statement he may choose to make.
    Mr. KANJORSKI. Mr. Chairman, we meet today for the first time since our subcommittee considered legislation in 2000 in response to the collapse of Long-Term Capital Management, to explore the issue of hedge funds. Created more than five decades ago, hedge funds have largely operated on the periphery of our nation's capitalistic system, with limited regulatory oversight, restricted investor access, and little public disclosure. Nevertheless, hedge funds, in my view, have played an important and crucial role in the ongoing success of our capital markets.
    Before we hear from the witnesses, it is important to review some basic facts about the size and scope of the hedge fund industry. Today, experts estimate that there are between 6,000 and 7,000 hedge funds operating in the United States. The hedge fund industry has grown substantially in recent years. According to several estimates, hedge funds managed $50 billion in 1990, $300 billion in 2000, and $650 billion in 2003. Moreover, although hedge fund holdings represent about 4 percent of the value of the stock market, the Wall Street Journal recently reported that hedge fund trading accounts are nearly one-quarter of the daily volume.
    As our capital markets have continued to evolve in dramatic ways during the last decade, hedge funds have attracted the attention of many of our nation's investors, particularly those who want to earn higher returns in today's chaotic markets. Because of their entrepreneurial investment strategies and their independence of the legal requirements applied to other securities products, hedge funds can generate positive returns even during bear markets. Additionally, hedge funds have attracted the attention of our regulators.
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    In February, for example, the National Association of Securities Dealers issued a notice to brokers reminding them of their obligations when selling hedge funds. Last year, the Securities and Exchange Commission also began comprehensive review of a number of issues related to hedge funds, including their recent growth, trading strategies, regulatory oversight, and transparency.
    In its investigations, the commission has also worked to examine the retailization of hedge funds. As my colleagues know, investor protection is a top priority of mine. From my perspective, a hedge fund is a very sophisticated securities instrument. As a result, only very sophisticated individuals with adequate resources and sufficient diversification should purchase this type of product for their portfolios.
    Hedge funds have also successfully operated with little regulatory scrutiny for many years, and we should not now add additional layers of unnecessary regulation in order to further protect those investors who are truly qualified to make these investments and already fully understand the risks involved.
    As we consider these issues, I would further encourage my colleagues on both sides of the aisle not to make quick judgments about changing the statutory and regulatory structures governing the hedge fund industry. Unless we identify something wrong, something that endangers our capital markets, something that poses a systemic threat to our financial institutions, or something that represents bad public policy, we should defer action in this area and await the recommendations of the experts at the Securities Exchange Commission and elsewhere. We additionally must move forward prudently and carefully in our regulation in these matters, in order to ensure that we do not cause further disturbances in an already turbulent capital market.
    Finally, later this morning I expect that we will hear complaints about short-selling, a strategy used by a number of successful hedge funds managers. I believe that this practice provides investors with an opportunity to use the information that they have about a particular company, industry or financial instrument to make money. This practice, in my view, is therefore a useful investment technique. It also helps to provide needed liquidity in our capital markets. Furthermore, it is perfectly legal. In short, when fairly practiced, short selling is an important offshoot of capitalism and we should not necessarily limit the practice.
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    Mr. Chairman, I want to commend you for bringing these matters to our attention. I look forward to hearing from the witnesses, especially Chairman Donaldson, who is testifying before us for the first time since he took over the helm of the SEC. I look forward to his valuable insights and leadership, and congratulate you for having these hearings, Mr. Chairman.

    [The prepared statement of Hon. Paul E. Kanjorski can be found on page 57 in the appendix.]

    Chairman BAKER. Thank you, Mr. Kanjorski.
Chairman Oxley?
    Mr. OXLEY. Thank you, Chairman Baker, and welcome, Chairman Donaldson, to the hearing. We are pleased to have him and certainly pleased to have him on board at the SEC.
    The growth of the hedge fund industry makes it incumbent upon this committee to examine whether there are sufficient investor protections currently in place. Pursuant to the committee's ongoing efforts to restore investor confidence, we are reviewing the financial products in our marketplace to ensure that investors are being treated fairly and appropriately. Some have argued that hedge funds are not an appropriate investment for retail investors. Others suggest that all Americans should be given access. Some have raised concerns about the lack of transparency in this industry, given its size, scope and impact on the markets.
    Our review of this industry will help us determine whether additional regulatory scrutiny is warranted, or whether additional regulations would actually harm investors and the markets. Indeed, hedge funds have served their investors well throughout the recent bear market. The average hedge fund has recorded impressive gains in these difficult markets, and done so with less risk than the average mutual fund. The industry has experienced considerable growth over the past decade, increasing in size from approximately $50 billion in assets to about $600 billion today.
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    In just the past five years, the number of funds has doubled, with about 3,500 new hedge funds opening for business. This explosion in growth has been fueled by good performance and a growing interest from large institutional investors, pension funds, charitable foundations and university endowments.
    Concerns have been raised that many financial services companies trying to capitalize on the exceptional performance of hedge funds have begun to market portfolios of hedge funds to retail investors. These funds of hedge funds are registered investment companies that typically invest in 20 to 30 hedge funds. They usually require lower minimum investments than traditional hedge funds. It is my understanding that these financial products available to institutional investors for some time are only being sold to investors who meet the income or net worth requirements of traditional hedge funds.
    While hedge funds are currently being sold only to accredited investors, it is my understanding that the funds of funds are only doing so because they do not wish to sell to retail investors. There may be a concern that, given the lack of a statutory restriction, they could in the future change their guidelines and sell to retail investors. I look forward to learning from Chairman Donaldson what the commission has found thus far regarding the access to hedge funds by these investors.
    Some question why retail investors are being denied access to these important financial risk-balancing tools simply because they are not wealthy. Today's panel will help illuminate this debate. Some have raised concerns about short-selling and its potential use to manipulate the market. I am pleased that the commission is examining these issues in its ongoing review of hedge funds in the markets, and look forward to hearing the views of Chairman Donaldson and our other witnesses on the effectiveness of existing laws prohibiting such activity.
    I applaud the SEC's year-long review of hedge funds, and eagerly await the forthcoming staff report. There are many important investor protections and capital formation issues to be addressed. This committee and the commission must proceed with an abundance of caution as we examine this industry which has served its investors well and provides important benefits to the markets. I am pleased, Mr. Chairman, to have this hearing and look forward to participating. I yield back.
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    Chairman BAKER. Thank you, Mr. Chairman. We appreciate your participation.
Mr. Emanuel?
    Mr. EMANUEL. Thank you, Mr. Chairman. I want to commend you for holding this important hearing on the role of hedge funds and their role in the financial markets. I would also like to thank Chairman Donaldson and our other distinguished witnesses. I have had a longstanding interest in this subject of today's hearings, going back to my service in the White House when the Long-Term Capital crisis occurred, and subsequently as an investment banker in the private sector. Last week, I had the opportunity to attend the SEC's roundtable on hedge funds. Chairman Donaldson and his team put together an excellent program by gathering a wide spectrum of the industry's participants and observers. We in the Congress also have a responsibility.
    As Chairman Donaldson said, take a long hard look at hedge funds, especially in view of the industry's rapid growth, the increase in hedge funds' share of overall market trading volume, a spike in fraud cases, and the retailization of hedge fund products.
    As this committee begins to gather information on the hedge fund industry, there are some fundamental questions we need to have addressed and begin to think about: to what extent is retailization of hedge funds a real problem; should the SEC require clear disclosure that address certain basic investor protections such as conflicts of interest, valuation, performance reporting, relations with crime brokers, and other service providers; should Congress and the SEC be focused on distinctions between accredited investors and ordinary investors; is the recent spike in hedge fund fraud cases the result of a few bad actors or is this a sign of widespread abuse.
    Finally, I would like to hear from the panel on systematic risk issues. As hedge funds' share of the market's overall trading volume increases, now more than 25 percent of all trades, what unique risks are posed? Additionally, has market surveillance by regulators and counter-parties improved enough since Long-Term Capital? Clearly, many hedge funds and fund of hedge funds have historically served their investors well and have made positive contributions to the market. Many hedge funds are non-correlated with equity markets and thus reduce portfolio risk while providing diversification. But it is critical that investors, particular retail investors and pension funds, receive the information they need to be able to assess risk, make informed decisions, and evaluate their investments on an ongoing basis.
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    I have the largest number of Illinois police, firefighters and teachers from the Chicago police, firefighters and teachers, and I am concerned that the current disclosure scheme may not be providing pension managers with adequate information. This is especially important in light of the fact that many pension funds now invest upwards of 5 percent of their capital in hedge funds. With the prolonged downturn in the market, we also have retail investors flocking to hedge funds to try to make up for lost returns.
    Therefore, if hedge funds are going to be accessible to retail investors and pension funds, and are going to be marketed to those parties, it seems to me that we seem to set some standards, not necessarily to restrict investor access, but to provide information in plain English to help people make good decisions.
    I also think that hedge fund managers should be held to the same lock-up periods and trading restrictions as funds of other investors. I am eager to continue working with my colleagues and the SEC to ensure that investors receive the information they need to make informed investment decisions. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, sir.
Mr. Toomey?
    Mr. TOOMEY. Thank you, Mr. Chairman. I would like to just briefly observe, I think it is useful to think of hedge funds as an asset class unto itself; one that allows investors to diversify their portfolio, and certainly historically earn superior returns relative to the risk that they take. It is also important to note that the nature of the trading and investment strategies of many hedge funds actually adds a refinement to the pricing mechanism in the marketplace, and makes financial markets in particular more efficient. To achieve those things, they often employ confidential and proprietary trading strategies which are a necessary part of the business and entirely appropriate.
    So I would just hope that as we explore this industry and learn more about its growth and the implications of that growth, that we bear in mind the significant benefits that this industry provides to investors, as well as to the efficiency of the marketplace.
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I yield the balance of my time.
    Chairman BAKER. Thank you, Mr. Toomey. Mr. Scott?
    Mr. SCOTT. Thank you very much, Mr. Chairman. I want to thank Chairman Baker and Ranking Member Kanjorski, and certainly welcome you, Chairman Donaldson, to this hearing today on hedge funds.
Because hedge funds do not typically register with the government, the data on the industry is not entirely precise. For the past year, the Securities and Exchange Commission has conducted an investigation of the hedge fund industry, and the commission's report will be released later this year. I certainly look forward to today's hearing as a good learning opportunity that may show or may not show the need for greater disclosure by hedge fund investors.
    I do think that we must move with caution. We do have to determine what measure of oversight is needed, what is the level of investment risk. I think there should be questions possibly on possible conflicts of interest. There certainly have been questions raised about questionable marketing tactics. My understanding is that the Securities and Exchange Commission has brought 26 enforcement actions since 1998. However, 12 of those actions have been in the last year.
    I think there may be some questions on the economics of the buyers, whether they have to have a certain amount of minimum wealth; should that be stated and regulated. I think it is an understanding that those who buy in the hedge funds should have certainly a minimum of $1 million in assets, or certainly at least $200,000 that have been accumulated in income each year. I think that raises a question, is this only a wealthy person's game? Is there room for more players at various levels of the economic spectrum, and if that a wise thing for them to do.
    I think also that one in five hedge firms have closed, certainly, in the last year after losing money through possibly poor decisions. But according to a recent study, 15 percent of those were due to sort of scam operations. So I think that there is evidence in dealing with hedge funds that we certainly need to look at them. They have certainly been very positive in many areas, but it is certainly an excellent opportunity for us to take a good look at them and hear from you to determine what recommendations you might offer this committee as we move forward.
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    I certainly want to thank this panel for your testimony today, and thank you, Mr. Chairman, for having this hearing.
    Chairman BAKER. Thank you, Mr. Scott.
Mr. Bachus?
    Mr. BACHUS. Secretary Donaldson, I want to praise you on another matter. You recently criticized the inclusion in the new bankruptcy act of watering down the disinterested rule as it pertains to prohibiting former investment bankers from acting as advisers to the bankruptcy trustee. That is a safeguard we have had since 1938, and I appreciate your testimony in the Senate saying that this is not the time to start watering down conflict of interest rules. I just want to commend you for that.
    I had actually offered an amendment here in the House to strike that provision. To reinforce what you said, the national bankruptcy review commission unanimously agrees with you that that would be unwise. It certainly would not restore integrity to the markets or confidence in the markets. I commend you for taking that position.
    Chairman BAKER. Thank you, Mr. Bachus.
If there are no further members desiring to make opening statements, at this time it is my distinct pleasure to formally welcome the Chairman to our committee. I am certain that over the coming months and years, we will have a very beneficial working relationship. I am particularly pleased by your already-demonstrated leadership skills. So it is my pleasure to welcome to Capital Markets Subcommittee the Honorable William H. Donaldson to make whatever comments he may choose to make.
    Welcome, sir.

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    Mr. DONALDSON. Chairmen Baker and Oxley, and Ranking Member Kanjorski and members of the subcommittee, thanks very much for inviting me to testify to discuss hedge funds generally and the Securities and Exchange Commission's ongoing fact-finding review of hedge funds.
    As you all know, last week the commission hosted a two-day roundtable on hedge funds. The event was a great success, in our view, and proved to be very informative and very lively. There was a great public interest in the event, both in the number of people who attended and those that listened on the Web cast. This public interest highlights just how important hedge funds have become. The roundtable was an excellent example, in my view, of how the SEC can operate as an effective regulator.
    By assembling a highly knowledgeable group of experts representing a variety of viewpoints, we were able to facilitate a debate on the important issues facing hedge funds, many of which you have alluded to just a few moments ago. I appreciate having the opportunity to discuss the roundtable and our fact-finding review of hedge funds with you today.
    As you know, the commission embarked on a fact-finding mission last year to look into hedge funds. The commission's division of investment management, alongside of our office of compliance, inspections and examinations, has been gathering information on a variety of investor protection issues associated with hedge funds. The staff obtained and reviewed documents and information from many different hedge fund managers representing over 650 different hedge funds and approximately $162 billion under management. The staff also visited and engaged in discussions with a number of different hedge fund managers. To complement our inquiries directed to specific hedge funds, the staff has met with a variety of experts, consultants, academics, and observers of the industry to seek their perspective. Participating in last week's roundtable were hedge fund managers, consultants, service providers such as auditors and attorneys, academics, prime brokers, investment bankers, investors and foreign and U.S. regulators.
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    These experts discussed key aspects of hedge fund operations, how they are structured and marketed, investment strategies that they use, how they impact our markets, now they are regulated, and whether the regulatory framework should be modified. Specifically, we had discussions that addressed, number one, the growth of hedge funds; number two, the hedge fund trading strategies and market impact; number three, trends in the hedge fund industry; four, the differences between hedge fund and registered investment companies; five, hedge fund fraud; and six, the regulatory framework applicable to hedge funds; and seven, investor education.
    Many people have asked why the commission determined to embark on its fact-finding mission at this particular moment. One of the primary reasons is because of the tremendous growth of the funds. Over the past few years, the number of hedge funds and their assets under management has continued to increase. As was reiterated last week at the roundtable, there are no precise figures, which is an indicator itself of a lack of knowledge available regarding the number, size and assets of the funds.
    This is due in part to the fact, and this I think is an important point, that there is no industry-wide definition of a hedge fund, in part because those that track hedge fund data rely on self-reporting by hedge funds, and in part because hedge funds generally do not register with the SEC. So we cannot independently track the data. Nevertheless, during our roundtable, knowledgeable sources confirmed their belief that there are between 6,000 and 7,000 hedge funds. I read in this morning's paper that another person thought that there were somewhat fewer than that; another expert source. The 6,000 to 7,000 have roughly $650 billion under management. Over the past few years, the panelists estimated that there have been on average $25 billion a year in new assets invested in hedge funds. One panelist estimated that in the next decade, assets under management in hedge funds will top $1 trillion. Institutional investor money, be it from pension funds, endowment, or foundations or other sources, account for an increasingly large percentage of these assets.
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    The commission has made significant progress in its hedge fund fact-finding mission, and we will continue to proceed with a focus on how to best protect investors and our securities markets. Additionally, we have called for public comment on the issues surrounding hedge funds. The public comment period will close approximately 45 days from today, on July 7. I view this as an important next step, as we will need to hear from all segments of the hedge fund industry, including those not represented at the roundtable, as well as those of the investing public. While we had many distinguished, thoughtful and helpful panelists, I am mindful that in such a public forum as a roundtable, we may have heard a guarded version of the state of the industry. It is our duty as the investor's advocate to ensure that we have all of the relevant information as we formulate a course of action.
    So while the roundtable was not the culmination of our fact gathering, and though we have not yet reached any conclusions, I have asked the SEC's staff to prepare a report to the commission on the current results of our various fact-finding efforts. The report will be delivered to the commission and I intend to make it publicly available shortly thereafter. I anticipate the report will address the key issues that have been a focus of our inquiry, including hedge fund trading strategies and market impact, the increased availability of hedge fund exposure to retail investors, the disclosures investors receive when investing in hedge funds, and on an ongoing basis the difference between hedge funds and registered investment companies, conflicts of interest including those created by the fee structures of hedge funds and funds of hedge funds, the role of primary brokers, hedge fund fraud, the regulatory framework applicable to hedge funds, and last and certainly not least, investor education.
    I have asked the staff to include in its report any recommendations for change in the regulatory framework governing hedge funds. I look forward to reviewing this report, analyzing the recommendations, and sharing the report with you.
    Thanks again for the opportunity to be here this morning. I would be more than happy to answer any questions you might have. Thank you.
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    [The prepared statement of Hon. William H. Donaldson can be found on page 59 in the appendix.]

    Chairman BAKER. Thank you, Mr. Chairman. I took time to carefully review your written testimony, which I found to be very helpful. The point upon which I have set most attention is that the management of the hedge fund may count a hedge fund as a single client, and under current rule until you have more than 15 clients, you are not required to register. Therefore, you do not really have the regulatory ability today to tell us who are these people that have entered into the market within the last few years, and their level of expertise in the management of these funds, which is cause for two further observations. One, with regard to the issue of retailization, which I still believe is minimal at this juncture, given the $200,000 income rule for two years, and a net worth of $1 million. That may need to be reviewed, and whether or not we are really seeing unsophisticated investors move into this market niche.
    But secondly, on a broader national scale, whether the significant growth in numbers and in assets under management, which you reference at this point and estimate at about $650 billion with an eye toward $1 trillion; the potential systemic risk, given inappropriate or sideways movement in these markets, without prior knowledge by the regulatory community. That is of significant concern to me.
    Another notch down on the scale, but still of significant concern, are those statements where short-selling activities appear not to be under the same regulatory scrutiny in the hedge fund world as it would be in the equities market, and the potential adverse volatility consequences that may bring about to the orderly function of the markets.
    Do you think it now advisable based upon the work to date that we at least ought to have management get a driver's license? We may not regulate how big a truck or how much horsepower, or how fast they drive or where they go, but at least shouldn't we know who they are so if we do need to find them, we have got that information? How do we bridge not getting in the business, with having adequate information to assess the risks for the public good?
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    Mr. DONALDSON. Right. Well, let me say a couple of things. First of all, I do not want to pre-judge the vast amount of data that we are bringing to bear on the subject right now. I do not want to speak for the commission, if you will, because ultimately the responsibility will rest there. But let me try and answer your question. Whether it is 6,000 or 7,000 or whether it is $600 million or $600 billion, that is a lot of money.
    Chairman BAKER. It is a lot.
    Mr. DONALDSON. And it is too much money for us to know as little as we know now about what is going on. I mean, fundamentally I would say that. Secondly, the regulations that are currently in force are confusing, and I will not bore you by going through all of them, but the funds are operating most of them under exclusions under the Investment Company Act and other exemptions under the 1933 and 1934 Acts. It gets confusing in terms of which exemption or which exclusion they are operating under. I think it says to us that we have got to take a hard look at these exclusions.
    If I can step back from that, and say that there are two trends going on here that were brought out at our conference and we are very much mindful of. First is that by and large, we have regulated hedge funds in so far as we have been able to regulate the registered ones, based on the assets and earning power of the purchaser. I think that calls into question whether that is the correct measure, because if you step back from the fluctuations that we have had in the marketplace, there is a perception, and it is probably more than a perception, that the hedge funds have fared better generally than our markets have, and generally than stocks have. There are a lot of ''retail investors'' out there who are pretty sophisticated, and who want to own hedge funds. So you have that on the one hand, and the statement is, why should only wealthy people have access to investment vehicles such as this?
    On the other hand, you have the counter-trend which is that the exceptions under which the hedge funds have been operating do not reflect if we were to measure them by current dollars, there are an awful lot of ''retail investors,'' if you will, or smaller investors who have moved up into this category. The question is, should the category be even higher in terms of exclusion, if that is going to be the criteria by which you let people in or out of hedge funds? So those two trends open Pandora's box in terms of what we should do about it.
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    And then the arrival of the fund of funds concept; the fund of hedge funds concept brings now, and that is a reflection of a demand in the marketplace. You have now registered vehicles, or vehicles seeking to be registered who themselves invest in hedge funds. Although they are voluntarily urged by us, restricting the kind of retail investor that can invest. In other words, that they are applying voluntarily, although they do not have to, because the parent company is registered doesn't have the exclusion, that they are basically voluntarily now limiting the size of an investment in these kinds of fund of funds. The problem is that the underlying investments, the underlying hedge funds themselves, most of them are not registered. We have no access to them. We cannot get inside of them. That is bothersome.
    I do not know whether that answers your question, and I do not want to pre-judge exactly what the commission will be doing in this area.
    Chairman BAKER. If I may, because my time has expired, it is clear to say that we need to know more. We are just not in a position today to establish what should be on the list to be identified in the way of detailed information until we do more examination.
    Mr. DONALDSON. My instinct, my personal instinct based on everything that I have heard is that we need to one way or another know more about this phenomena, if you will.
    Chairman BAKER. Thank you, Mr. Chairman. Mr. Kanjorski?
    Mr. KANJORSKI. Have you seen any indications of fraud or abuse of any large amounts that would warrant the Federal government getting involved further in this issue? Or is it just curiosity on the part of the commission?
    Mr. DONALDSON. Which issue, congressman?
    Mr. KANJORSKI. On hedge funds; the activities, who is in them, what they are investing in, what they are doing.
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    Mr. DONALDSON. Again, there are, as was mentioned earlier, we have brought enforcement actions, and although they are relatively few; I mean, there are 25 or so enforcement actions that have been brought over the last three or four years; but over half of those have been brought in the year 2002. Those enforcement actions cover a range of things; hedge funds cannot advertise under our current laws; there are all sorts of things that these people were doing that we have brought action.
    However, if you look at the total number of hedge funds, 25 actions is not that much. If you look at the number of actions, if you will, that we bring in the whole mutual fund industry, and imputed that to this industry, you would say that there were more actions out there that needed to be taken. That is a leap of judgment on my part, and we need to know more about what is going on inside some of these funds.
    Mr. KANJORSKI. What time frame do you see arriving at a definition of what a hedge fund is? It seems to me quite a challenge.
    Mr. DONALDSON. I am not sure we will ever come up with a definition that is broad enough or meaningful enough. As you know, the whole hedge fund concept started many years ago, and it was quite simple. They are quite simple, and the idea was that instead of just buying and going along with stocks that you liked, why not at the same time sell stocks short that you did not like. That spreads your research effort, if you will. You go down a pike and look at a company you decide you do not like, and as a matter of fact you think it is overpriced, why not short that at the same time you are buying something that you like. That was a pure hedged vehicle, and the combination of being made sort of market-neutral, if you will, where no matter where the market went, you were balanced here with a long and short position, allowed borrowing to be inserted on top of that; leverage.
    Now, as time has gone on, the term ''hedge fund'' applies to all sorts of investment techniques; macro techniques to commodity funds to pools of capital that are doing all sorts of things. I think that too often the word ''hedge fund'' is applied to a freestanding pool of capital that is not hedged at all; that is doing lots of different things. I think we need to know more about what those things are. We get at that, and this is probably a subject that you may want to get into, if there is some sort of market manipulation, if you will, associated with those techniques, we have the right right now to go at market manipulation and fraud in the marketplace. If it is out there, some of it is out there outside of hedge funds.
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    It is not a new phenomenon that people try to manipulate the market. Hopefully as our human resources increase at the SEC, we are going to be able to be much more broadly involved in uncovering that.
    Mr. KANJORSKI. You are interested in that issue, I assume, Mr. Donaldson?
    Mr. DONALDSON. Absolutely.
    Mr. KANJORSKI. Do you think the Congress should get off its duff and act as soon as possible to give you that authority to get more people?
    Mr. DONALDSON. To go one step further, the modern age we live in, and in particular the Internet, ups our challenge many-fold in terms of, you know, there are prohibitions on hedge funds from advertising, as long as they are operating under the exemption. A part of the exemption is they cannot advertise. There are obviously prohibitions on market manipulation. However, we have the Internet out there, and we have a whole new communications media, and we have a special group of people in the SEC now that are looking at the Internet as a source of possible market manipulation. But it broadens the scope of what we have to look at.
    Mr. KANJORSKI. Just one other question; myself, I will sort of go with the rule that the we get the least involved we can, except for either trying to protect against systemic risk or fraud and activities that may be going on that we discover, but apparently, we have not discovered that to a large extent. I am worried about the insured institutions that are providing some of the lending to these hedge funds. Have you had adequate reporting and has the regulators of these insured institutions received sufficient information to have a pretty good handle on just how much of the insured deposits are being placed and used by hedge funds? I guess another way of asking the question, are the $650 billion; what portion of that is coming out of the banking system or the insured system?
    Mr. DONALDSON. I think that, you know, if the question you are asking is, do we have adequate resources now, human resources, inspection resources and so forth; I think we are headed toward that, if we can implement the authority that has been given to us and add the people that we want to add. I think that the evidence so far is that we do not see the broad gauge manipulation as the image is out there.
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    That is not to say that it is not there, and I do not want to make a judgment on that. As I said earlier, and I want to emphasize this, that if you took the general tenor of the conference we had a week ago, it was rather reassuring as far as I was concerned. Just trying to make an overall judgment, it was rather reassuring. On the other hand, we did not expect people that were possibly doing things that we think violate the law to come and talk about that in an open forum. So I want to assure you all that we are not stopping with just the two-day forum we had.
    Mr. KANJORSKI. When your report is concluded, would you recommend that the committee have another hearing to receive your report, your analysis and conclusions on it, and any recommendations you may have for legislation?
    Mr. DONALDSON. We would be absolutely delighted to sit down with you all and as a first step give you what we have. We will give you what we have with our recommendations, and I have no idea what those recommendations will be, but we certainly would want to explore them in any forum that you think makes sense, particularly this one.
    Mr. KANJORSKI. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Kanjorski.
Chairman Oxley?
    Mr. OXLEY. Thank you, Mr. Chairman. By the way, happy birthday to the Chairman. Our crack staff gave me that information. I assume it is accurate.
    Chairman BAKER. I am taking it regardless.
    Mr. OXLEY. Okay.
    Chairman Donaldson, the recent changes in the law in the Congress as well as at the SEC and the SROs have dealt with the manner in which analysts are evaluated and compensated in order to eliminate conflicts of interest between their desire to serve two masters; the corporate clients and retail investors. I think we are making some progress on that issue.
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    If an analyst were to issue a research report that does not reflect his own personal views of the covered security, that would be indeed a violation of the recent rules, is that correct? We have heard concerns that some analysts have been pressured to downgrade companies in order to curry favor with short-selling hedge funds that happened to be an important client for the analyst's firm, generating millions of dollars in revenues. That also would be a violation of the current laws and regulations, is that true?
    Mr. DONALDSON. Yes, it would.
    Mr. OXLEY. Could you tell me, is there any effort by the commission to investigate and take action against this type of abuse?
    Mr. DONALDSON. We are particularly interested right now on the follow-up to the settlement. Okay? We have put some rules and regulations in and we are not going to just let it sit there. We are out in the field and making sure that there is conformity. Obviously, one of the aspects of the settlement and so forth has been the signing of the analyst's report and the analyst pledging that this is his or her view. The instance that you bring up has not been brought to my attention. That does not mean that we are no looking at it, but we would respectfully request that any sort of information like that be brought to our attention and we will do something about it. I just want to assure you that that would be a fraudulent act; what you cite there.
    Mr. OXLEY. And that would be in the province of your enforcement division?
    Mr. DONALDSON. Yes.
    Mr. OXLEY. Thank you. In light of yesterday's press accounts, I would like to get your views on the practice of revenue sharing, whereby brokerage firms are paid by mutual funds for distribution. Without commenting on whether the agency is currently investigating this practice, I would like to have your views on the following: whether these payments are appropriate; whether you think investors are aware of this practice; and whether such payments should be disclosed to investors.
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    Mr. DONALDSON. Right. Let me just go back to your prior question, and just clarify that we would pick up what you talked about in terms of an analyst not performing according to the law. We would pick it up on the inspection side of the SEC. If we found evidence of that, we would turn it over to our enforcement people, but we would have our inspection people especially aware of the possibility of it. In terms of the mutual fund question you bring up, we are currently looking at the sales practices of mutual funds within the broker-dealer community to begin with.
    What we are concerned with is there are laws that govern special incentives that are not disclosed to the sellers of mutual funds. We are concerned and therefore out investigating as I speak now the various practices and whether these practices are either violating the laws that exist now or violating the spirit of the laws that exist now. Our bottom line goal is to assure that a potential mutual fund investor through an investment banking firm is aware of all the compensation or inducements that are being paid to the broker that is selling them, not only to the broker, but to the broker's manager.
    Mr. OXLEY. How much of that is currently revealed?
    Mr. DONALDSON. I am sorry?
    Mr. OXLEY. How much of that information today is currently revealed to the shareholder?
    Mr. DONALDSON. I would say not enough. I would say that the average; there is disclosure, but I think that there are more subtle ways of incenting brokers to sell particular funds that the purchaser does not know. I am leaping ahead of the work we are doing now to document that, but that is my own personal opinion and the reason for us being out in the field right now examining that.
    Mr. OXLEY. Do you think a revenue-sharing arrangement is a conflict of interest on its face?
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    Mr. DONALDSON. What kind of——
    Mr. OXLEY. The revenue-sharing agreement; would you consider that to be a conflict of interest simply on its face?
    Mr. DONALDSON. At the very least, it is a piece of information that a prospective buyer has a right to know. A prospective buyer, in my view, has a right to know what incentives lie behind a recommendation. I believe that that is what we are after.
    Mr. OXLEY. Thank you. Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Chairman. Mr. Scott?
    Mr. SCOTT. I would like to kind of carry that thought just a little further, and talk about mutual funds and the hedge funds. I think it is true that brokers, prime brokers and advisers can manage both hedge funds and mutual funds. I would like to ask you to respond to that in terms of whether that is a possible area of conflict, particularly in view of the fact that over the last period of time, I think there has been an 11 percent increase in the profits accrued from hedge funds, and almost an identical 11 percent loss in the return on mutual funds. That in relationship to the conflict of interest; I mean, that almost begs for some examination. Then I have a follow-up question, but I would like you to respond to that one first.
    Mr. DONALDSON. It is a very good question, and I think that clearly the hedged vehicles generally speaking have done better than unhedged vehicles, long-only mutual funds during a period of market decline. That is not to say all hedge funds have done better, but on average they have done better than on average what mutual funds have done. This creates an environment in which I would imagine there is considerable pressure in certain mutual fund organizations to have a line of products of hedge funds.
    There is consumer demand out there. The conflict, if I understood your question correctly, there is always a potential conflict in a mutual fund family as between the various funds they are running, in terms of who buys first and that sort of stuff. That is pretty darn well regulated right now. But if in fact the laws were changed to allow the fund of funds concept to move into the mutual fund family, that again opens up a potential for conflict. So you would not do that quickly, but as I said earlier, I think there is a demand for hedge funds, and that is quite natural that it is coming at a time when long-only equity investing has been through such a difficult period.
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    Mr. SCOTT. Do you think that, if I am correct, that they have the right, the managers, to manage both of those funds and yet also operate under privacy? Do you feel stripping them of that privacy right would open up and make it——
    Mr. DONALDSON. I think what you are asking, I think, is I think we need to know more than we do about what is going on in the general area of hedge funds. I think the place where one would question whether we should go to, and I would have personally serious questions, is whether the funds are under an obligation to disclose exactly what they are doing, because that is a proprietary competitive fact. I think any attempt to display that would be counter to principles of people being able to build a business based on a special expertise. This is where I think we have to be very careful in terms of regulating the actual techniques being used.
    Mr. SCOTT. Let me ask you this other question. Do you believe that smaller investors will be able to participate in similar activities in the future of hedge funds? Do you believe that hedge funds will remain what it is right now, essentially an investment tool for more wealthy individuals? Is it possible or are there efforts to try to open it up so that more middle class Americans would be able to benefit from this?
    Mr. DONALDSON. I would say two things. One is I think there is a definite need to examine how hedge funds, properly run and properly disclosed, can be allowed to be purchased by retail investors, number one. I think number two is that there is a danger here that because of the particular market circumstances that we have had, and the relative performance of the stock market long-only mutual funds versus the hedge funds, that a tremendous new amount of money comes in, and as the new money comes in, the opportunities to operate in that niche profitably probably become less and less, so that the hedge fund returns, perhaps, are not quite as great as they have been in the past, or won't be. I think we have to guard against that in terms of the rapidity with which we examine opening funds up to lesser investors, to retail investors.
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    Chairman BAKER. Can you wrap up?
    Mr. SCOTT. Thank you.
    Chairman BAKER. Thank you, Mr. Scott.
Mr. Toomey?
    Mr. TOOMEY. Thank you, Mr. Chairman. Chairman Donaldson, I guess my question has to do with the additional information that I understand you to be suggesting I think intuitively that you feel you ought to have. My question is, you know, since we have an industry here where there is limited access, really it is by and large for the most part it is high net worth individuals. We have got very few cases of fraud. We have got an industry that is contributing to market efficiencies and providing superior returns to investors. Since there is a cost of complying with any new regulatory regime, there is a cost to providing information, I guess I am wondering what is the harm that is being done that warrants demanding more information or regulation, or what is the danger that you are worried about that would justify creating a new demand on an industry, which would of course have to pass that cost on to its investors?
    Mr. DONALDSON. Yes, it is the old cost-benefit analysis that needs to be done. Clearly, I think what I am suggesting, and again this is my own personal view, is that the minimal level of gaining a right to examine hedge funds is not that costly, and the benefit to our society would justify that. It is what comes from that that is the big question. I make no judgment. All I can say is that we just do not know now what we do not know, if you will. I think that if what you are suggesting is do we need a huge new overlay of regulation, I just do not know. I doubt it right now, but we need to get the information to see whether we do.
    Mr. TOOMEY. I guess that leads to another question, then. What kinds of things would you want to know that would be useful in terms of; I guess there is a concern that maybe something we do not know is out there that poses some kind of systemic risk to our markets or some significant risks that investors do not understand. I think most investors know that there is inherent risk in this kind of investment. I am trying to figure out what kinds of information would help in preventing those sorts of things, without undermining what you I think quite rightly recognize as the necessarily proprietary nature of the investment strategies.
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    Mr. DONALDSON. There are, again, for a large portion of hedge funds, we do not have the right to go in and take a look at what they are doing. So what would we be looking for when we go in and look at what they are doing? We would be looking at their books and records; we would be looking at the way they value securities. Again, if I am running a fund of funds and I have in my portfolio a hedge fund, and that hedge fund has to be valued on a quarterly basis or a monthly basis, how are those valuations being made? Those are the kinds of information that I think we need to take a look at. Books and records and the way the hedge fund is organized; all of these things we just do not know and we do not have the right right now to go in and look.
    Mr. TOOMEY. Now, financial institutions that extend credit to these funds, they do undertake that kind of analysis. Or do you think that they do an inadequate job of understanding the answers to those very questions, so that they can make an informed credit judgment about the hedge fund?
    Mr. DONALDSON. I think there has been substantial improvement in the responsibility and oversight of the prime brokers. They have a vested interest in that. They are lending money and so forth and so on. On the other hand, the funds are very good customers of theirs. So it is hard to tell exactly what is going on inside some of these funds. We had one of the largest investors at our conference, a major investor who one would think, who is a large purchase of hedge funds, and the question was asked, you must have buying power so that you can get inside some of these funds and ask questions that even a regulator cannot before you make an investment. The answer was, we have difficulty getting the information from a lot of these funds. Again, my supposition here is that the funds with very good records, that is the one that a fund of funds would want to buy, but everybody wants to buy it and so the fund says, we are not going to tell you. You can buy our fund or not. That forces the investor, the institutional investor to go to lesser funds with lesser records.
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    I guess what I am trying to say is that even those who have the market power to demand more knowledge about what is going on in funds that they want to buy are having trouble getting that; at least that is the partial evidence that we are getting right now.
    Mr. TOOMEY. Thank you.
    Chairman BAKER. Thank you, Mr. Toomey.
Mr. Emanuel?
    Mr. EMANUEL. Thank you, Mr. Chairman. I, too, want to wish you a happy birthday, just so it is bipartisan in its approach.     Chairman BAKER. I take it in that spirit. Thank you.
    Mr. EMANUEL. To try to follow up on what my colleague was asking, but from a different side, we have mentioned that hedge funds have about $600 billion now in the market, and you can estimate somewhere between 6,000 to 7,000 hedge funds exist. But all the recent articles and studies I have read show that close to about $2 trillion over the next five years will be involved in hedge funds. Today, a little less than a quarter of the trades are done by hedge funds.
    That will grow to over one-third to bordering up near 40 percent. Two other events, I think, raise the proper concern why you had the two-day conference, why are having this hearing, the first hearing by Congress since Long-Term Capital, which is this is an instrument used by wealthy investors that is now being exposed to a larger audience; what we normally call retailization. That is one trend; not a negative or a positive. It is just a trend.
    The second is that we have a lot of new entrants in the area managing funds who have never gone through the Long-Term Capital experience. So you have a retailization, new entrants managing funds, and a market unlike mutual funds or anywhere else like on the street, it is the only area where people do not have to register, do not have to give any information about how they trade, how they perform, any transparency. There is no other instrument like that; no other fund like that.
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    This is the only one that exists, and you have two events happening simultaneously in the market that raise questions.
We have tried many ways, and I compliment you; you have obviously adapted well to Washington since nobody can get you to go on the record or comment on your views or what happened during those two days, and your estimate, so you have done very well at adapting to Washington; no answers to any questions yet. But if I can at least get you to comment on after the hearing, Commissioners Glassman and Campos commented that retailization is not a concern in the hedge fund industry.
    At least what I have heard you; you have not said you are not not concerned; that is a double-negative; but do you at least have some comments about the other commissioners' comments that they are not concerned about retailization. Do you see any kind of flashing yellow light that exists to the retailization of hedge funds, an instrument prior to this point being solely that for high net-worth individuals?
    There are about four questions in there. Go ahead and pick any one of them.
    Mr. DONALDSON. In the spirit of the openness of our two-day conference, I think that both of those commissioners were reacting to, perhaps making a statement to see if it would be challenged by the audience. In other words, I think they were in a learning process, as we all were. I think that I would revert back to what I said earlier, which is that there is a market demand for retailization, and that brings into question whether the relative sophistication of the ''retail'' customer or client, and I would submit that there are lots of people who do not have the assets that are currently required for an exclusion, that are very savvy investors, and perhaps should have a right to participate in these vehicles. If that is true, then we have got to somehow take a look at how we can make whatever the risks are inherent in these funds readily available to a less sophisticated retail investor. That is the problem. That is the opportunity here, and there are strong arguments. Again, I am giving my own personal opinion in terms of the trend here.
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    There are also hedge funds being set up all the time. Some are large and sophisticated and run by experienced people; some are small, new groups breaking off from, maybe they were in the research department somewhere on Wall Street or they were somewhere else and they said, let us go start a hedge fund, and they are getting into the business. I am concerned about that. I am concerned about the proliferation of hedge funds, and I think we have to take a look.
    Mr. EMANUEL. Do I have time for one more or not?
    Chairman BAKER. One short one, please, sir.
    Mr. EMANUEL. Okay. The last question is, the requirements under the accredited investor, do you think those requirements are still at the right place? Would you make any changes to them?
    Mr. DONALDSON. I am not prepared to comment on that yet. I really, again, and I would love to. I do not want to read in the record and bore anybody here with the various exclusions and exemptions and so forth. I would say that we have to take a hard look at the current exemptions and so forth.
    Mr. EMANUEL. Thank you.
    Chairman BAKER. Ms. Biggert?
    Mrs. BIGGERT. Thank you, Mr. Chairman, and welcome Mr. Chairman also. Some have suggested requiring that the hedge fund advisers be required to register under the Investment Advisers Act. If the advisers of Long-Term Capital Management had so registered, do you think that that would have prevented the bankruptcy of that hedge fund?
    Mr. DONALDSON. I think that Long-Term Capital, again, was a very special sort of hedge fund which had a very special area of operation, which used large, huge amounts of leverage. I think that the approach by the President's working group which brought together not only the SEC, but the Treasury and the Federal Reserve, got at the multi-dimensional aspect of Long-Term Capital. I think that the oversight now into the counter-parties and the lenders and so forth, which extends beyond the SEC's purview in certain cases, has been pretty well closed. It is in a lot better shape today than it ever was before. So I am not; I think that is in pretty good shape; that kind of spectacular——
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    Mrs. BIGGERT. I guess to me, or looking whether there would be mandatory registration of any of the hedge funds, and if there was that registration somehow would it be presumed by investors that these hedge funds are less risky because of having SEC registered status as their adviser?
    Mr. DONALDSON. Again, the use of the word ''registration''—there are all sorts of different levels of registration, as you know. The simplest level is the registration of the manager, if you will, as opposed to the fund itself. Clearly, registrations of the funds under the 1933 and 1934 Acts is a vast and very costly thing. The simple registration of the manager, if you will, which is a relatively inexpensive thing to do, and it opens the door for the regulators to get in and look and see what is happening.
    Mrs. BIGGERT. I think that some of our witnesses later on are going to suggest or believe that retail investors then should not be denied the ability to invest in these funds. Somehow we seem to be talking about that hedge funds are risky, and yet if we have an open policy, their proprietary interests are looked at and will actually make the hedge funds go down, as far as the amount of money that can be returned, because other people will get into what they are doing. So do you think that the funds that if the retailers got into, and I think you suggested earlier that these funds would help to reduce the risk in an investor's portfolio, and yet we think of them as the high risk funds.
    Mr. DONALDSON. Again, if you listen to the successful hedge fund managers and if you listen to many academics and so forth, that they would challenge the risk aspect. They would say, with some conviction, that these funds because they have broader powers than long-only mutual funds, that they can reduce the risk; that they can make money in any kind of a market, is what they would say, and that in fact the risk is not as great as somebody that has invested in a fund that has to just invest in common stocks. So I think there are other kinds of risk. There is risk of leverage and there is the risk of records and books and an honest operation. Those are all part of the risk package, and I think we need to be able to take a harder look than we can right now at those risks. I think what comes out of that remains to be seen in terms of how far it is advisable to go to allow ''retail'' investors to invest in these funds.
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    The bottom line is that we have got to somehow make investment opportunities available to everybody in this country that wants to invest. We cannot put a fence around a particular investment vehicle, but at the same time we have got to be sure that the investors understand the risks inherent in doing that.
    Mrs. BIGGERT. Thank you very much.
Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Ms. Biggert.
Mr. Capuano?
    Mr. CAPUANO. Thank you, Mr. Chairman. Chairman Donaldson, first of all I actually like most of what I have heard today, though as to be expected I have to pass through a fair amount of it. That is okay; that is expected. I apologize for asking what might be a simple question, but when do you expect to have the report finalized? Is there any time frame at all?
    Mr. DONALDSON. As I said, we are going out; 45 days from today we will put a cut-off on comments coming from either those who were at our conference, who have read about it or saw it on the Web and so forth. We also hope to complete our further investigation outside of the conference, and I would hope that sooner rather than later we will have a report to you. If I were to put a; if you do not hold me to it exactly, but to give you a parameter, I would hope that sometime in the early fall, by the end of the summer and early fall that we will be back to you. That is our thinking.
    Mr. CAPUANO. Thank you. Just a couple of comments before I get a question. I would disagree that you have the ability at the moment to regulate hedge funds if you chose too. Everyone looks to the SEC. I know you have some general powers to basically regulate the trading system, to oversee the trading system, and I would throw hedge funds into that. That is my interpretation, not necessarily yours.
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    In response, I would have liked to have heard a stronger response as to why you think it needs to be regulated. Anyone who trades at 25 percent of the trades going on deserves to be overseen by somebody. The degree of that oversight might be subject to debate, and that is fair, but somebody should be looking at what they are doing. I guess for me, I am reasonably satisfied with the direction things are going. I am not satisfied with the speed, but that is the normal situation in a large government.
    I guess for me, one of my concerns is, I am hoping that whatever you are thinking about doing, you are also doing in coordination with other regulatory agencies, and particularly those of financial institutions. And I would hope that; is that an accurate commentary or am I off on that?
    Mr. DONALDSON. I keep getting back to the various exclusions and exemptions and so forth in terms of our powers, if you will, to regulate, or to even stop short of that; our powers to get inside and know what is going on. That is, I think, a minimal level that this amount of money, $600 billion and growing rapidly, requires. I do not want to pre-judge what we are going to find here. I do not want to pre-judge what the balanced judgment will be coming out of all the work that we have done.
    But I think it is just a simple statement that if somebody, if we use this figure; 6,000 to 7,000 hedge funds; $600 billion; and somebody who has spent days and days and hours analyzing it, and a report in the paper today that there are really only 3,000 funds out there, or whatever; it simply illustrates that we do not know.
    Mr. CAPUANO. Fair enough, Mr. Chairman. But my concern has never been for the wealthy investor who is very knowledgeable about what he is doing. My concern has always been the impact of these hedge funds on other investors. The last time, through Long-Term Capital, my concern was not for the individuals who may or may not have lost money. My concern honestly in that situation was who allowed the bankers and the other financial institutions to make investments without ever telling anyone that they had done it. Not an SEC problem so much, but a problem with other regulatory agencies, because they were jeopardizing my money investing in a bank, as opposed to if I go into a hedge fund, I know what I am into, so be it. My interest in regulation is really not so much regulation in the classic sense, as much as transparency. Again, not so much for if it is going to be limited, but as hedge funds open their doors; which they are doing; you know it; you have said it; we all understand that as they open their doors, they bring in less sophisticated investors and they also broaden their ability to move that market.
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    It is the transparency. If you know what you are getting into, if you know your money is at risk, well, fine. You are entitled to make that risk. For me, it is the transparency that is the most important thing. In this particular situation, one question I have for you is right now, even with the limits that are there, a million dollars net worth in today's society in places like New York and San Francisco and Boston and Philadelphia is your house, that you might have bought 20 years ago.
    And who is sitting there right now telling me or telling you that they are adhering to those limits? My house might have been worth $1 million last week, but with the current economy maybe it is only worth $700,000. Can you sit here today, or can anyone tell me today, that even with those lowered limits, that we are not actually getting investors in? I have seen advertisements for hedge funds in various financial papers. If that is the case, who is telling me; who is making sure that those less sophisticated investors are not being welcomed in? Who is sitting there guarding the gates?
    Chairman BAKER. That will have to be the gentleman's final question.
    Mr. DONALDSON. I want to draw a distinction between the desire to have more information about what is going on in the hedge fund, as opposed to our existing laws which allow us to get after fraud and manipulation no matter where it comes from. So we do not need any further powers to do that.
    In terms of the issue of financial viability as a criteria; net worth and earning power and so forth; as I tried to explain, I think that that may not be the only criteria that should be out there. Again, you get to the issue of suitability and you get to the issue of transparency and suitability, and there are laws on the books about that, too, in terms of what you are talking about. I am not prepared sitting here today to give you a prescription. That is what we are trying to get at; exactly the question you are talking about and a lot of the other questions. We are trying to understand it ourselves, and we are trying to make some measured judgments based on data and based on the testimony and the investigation that we are doing.
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    Chairman BAKER. Thank you, sir. Ms. Kelly?
    Mrs. KELLY. Thank you very much for holding this hearing.
    Mr. Donaldson, we come from the same home town. I am just delighted to have you here, proud to have one of my constituents in your position. We all cheered when we heard you were appointed. So I am glad to have you here.
    Sir, we know today that significant long positions in securities have to be disclosed, while significant short positions are not subject to the same kind of disclosure. In your testimony, you mentioned that you believe that the current level of disclosure provides some information on both long and short security positions.     I am wondering if you think that there should not be some kind of a significant short position disclosure whether by a hedge fund or any other investor, trying to figure out what is going on, that parallels the treatment of disclosure with respect to long positions.
    Mr. DONALDSON. There is, as you know, on the long side of the market, there is a 5 percent level of disclosure. If you go over 5 percent, you have to disclose it on the long side. In fact, the evidence that we have is that the short positions of hedge funds and others do not come anywhere near that 5 percent level in terms of 5 percent of the total capitalization. That is number one.
Number two is that the self-regulatory organizations; the NASD and the New York Stock Exchange; in particular have requirements where short positions are published on a monthly basis. I believe it is monthly.     So they do know in a gross way the long-short position in a wide range of stocks. If you are suggesting that there needs to be a public disclosure fund-by-fund of exactly how much money they have in a short position, and the name of the stock and so forth, and publish that, I think we have to take a look at that.
    Mrs. KELLY. I am glad to hear you say that, sir, because I analogized this for the investors as being somebody who went on vacation and accidentally dropped their essential glasses in a lake. And they are looking down in that lake and it is slightly murky. They can see the glasses on the bottom of the lake, and they really want to get those glasses. They want to get into the lake, but they are not sure if there is an alligator in the lake. That is what I view some information as being. I think if we are going to build investor information and investor confidence in this market, we have got to make sure that you tell them through transparency and other ways that there is no alligator in the lake and they can get in and do what they want to do.
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    That being said, I have got one more question, and that is, last August, the NASD issued an investor alert that was entitled Funds of Hedge Funds: High Costs and Risks for Higher Potential Returns. As pooled investments, these funds of funds are described as pooled investments in several unregistered hedge funds. The funds of hedge funds can have a minimum of $25,000 and have an unlimited number of investors. I am wondering if you feel that these funds of hedge funds could represent a danger to less sophisticated investors and what you think we should do about that.
    Mr. DONALDSON. The fund of funds that are invested in hedge funds; the vehicles, the parent company are registered vehicles and have to conform to our existing laws. The issue as far as I am concerned is the underlying investments; the hedge funds that they are investing in. Here, as I said before, we do not have enough information and I am not sure that some of the funds of funds have enough information about what is going on inside these units. And this becomes particularly pertinent in terms of evaluation of these investments in the hedge funds. In other words, if somebody is putting their own price on what their performance is without some oversight there, there is room for abuse. So I think as a first step, we just have to know more about what is going on.
    Mrs. KELLY. Thank you. Mr. Chairman, I just want to offer one more comment. I want to thank the SEC for the Web site. I think it is laudable that you have already set up the GRDI Web site; the Guaranteed Returns Diversified Incorporated. That is a wonderful way to do outreach to educate investors. I am very hopeful that more; you say in your testimony that you have had 80,000 hits on it. That is terrific. Investor information, investor education is again one of the ways that I believe we can help people understand what they are getting into, and then they will get in and they will be in the market. Thank you, sir, for appearing. Thank you, Mr. Chairman.
    Chairman BAKER. I thank the gentlelady.
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    Just be advised, if you are on vacation in Louisiana and drop your glasses in the lake, there is an alligator in every one of them.
    I almost overlooked my distinguished vice Chairman, who has returned from other duties to join us today. Welcome, sir. I know. I was trying to overlook you, but I forgot.
    Mr. OSE. Thank you, Mr. Chairman. Chairman Donaldson, I have asked this question at every meeting regardless of subject, and I am going to ask it again today. What is the status of the application of Nasdaq for exchange status?
    Mr. DONALDSON. The issue of Nasdaq becoming an exchange, registered as an exchange, has very broad implications to it. There are bits and pieces of market structure now that need care in terms of how we resolve them. I think that the application of Nasdaq has to be viewed in the context of the overall market structure. That is exactly what we are doing. We are talking to the Nasdaq people in terms of trying to resolve some of the obvious objections we might have to the way they are set up now. More importantly, I think we see this as part of an overall market structure issue, and we have that under review right now.
    Mr. OSE. Has the application been deemed complete?
    Mr. DONALDSON. I think too often we have taken market structure issues and solved them piece by piece without knowing exactly where we are going. I think that the time has come to take an overview of the entire situation and see what the central marketplace should look like. I think we are trying to do that. I want to assure you that we are not just sitting on that application. We are working very hard to have an overall view of how this total market is evolving.
    Mr. OSE. So their submittal is complete or it is not complete? In other words, the requests that SEC has made of them and they responded and given you everything that you have asked for in terms of submittals?
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    Mr. DONALDSON. I think that, as I say, the issue of Nasdaq's registration, the thing that is before us, the whole issue of public ownership of markets, of where regulation fits; these are big issues and I think we have to look at them as part of a whole, and not piecemeal address things that come into us unless we understand what impact that has on the whole.
    Mr. OSE. So how much time is it going to be before we come to a conclusion on this matter?
    Mr. DONALDSON. I do not want to put a timetable on it. I will say that some of the market issues and market structure issues have been around for quite a while. I think that we are seeing enough pressure now in terms of new markets, of electronic markets, ECNs, internalization; a whole series of things going on in the marketplace to know that there has to be an overall structure here, and that we cannot just address this thing in an ad hoc way.
    Mr. OSE. So there is no time frame in which you are planning to get to an answer?
    Mr. DONALDSON. It is a very high priority for us. Let me put it that way.
    Mr. OSE. We have been at this; I believe they actually initially filed two years ago.
    Mr. DONALDSON. Yes, I have only been at it for three months.
    Mr. OSE. I understand that. And you have not fixed it, and I am just appalled.
    But I do appreciate you looking at it. It is a subject that I find timely, given our needs to have markets of some form or another operative in the event of an incident.
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    Mr. DONALDSON. Right.
    Mr. OSE. So next time I see you, I am going to ask you the same question. I am sorry to bring it up in the context of hedge funds, but I asked your assistant when we did the last hearing; mutual funds, thank you; so I am interested in seeing you come to a conclusion on that particular application.
    Thank you, Mr. Chairman.
    Chairman BAKER. Thank you, Mr. Ose.
    I am making sure no one else is waiting. I do appreciate your appearance here today. It has been helpful to the committee. I would express a deep interest by all members of the committee in the advantage of the study and report which the agency is generating on this matter. We would certainly want to return for a public discussion of those findings, specifically if there are recommendations that would require any action on our part.
    In the meantime, we perhaps will proffer our own questions for inclusion in the public comment period on issues raised today by many members concerning the transparency and adequacy of the current regulatory structure. We look forward to working with you on this and many other matters of interest in the coming months.
    Mr. DONALDSON. Terrific.
    Chairman BAKER. Thank you, Mr. Chairman.
    Mr. DONALDSON. Thank you.
    Chairman BAKER. I would also invite our second panel forward at this time. I would like to welcome the members of our second panel. I would like to request each member if possible to constrain your remarks to five minutes. We will make the full written testimony part of our official record for further evaluation by the committee. We welcome each of you here. First, Mr. John Mauldin, President of Millennium Wave Investments. Welcome, Mr. Mauldin.
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    Mr. MAULDIN. Thank you, Chairman Baker. I thank you for allowing me to share some thoughts on the important matter of who should be allowed to invest in hedge funds. My name is John Mauldin. I am President of Millennium Wave Investments. I have been involved in the alternative investment world since 1989. I speak at investment conferences on a wide variety of topics on hedge funds, and I write a weekly letter that goes to two million readers each week.
    Let me summarize quickly my written testimony. It is my contention that the positive values that hedge funds offer to rich investors should also be offered to the middle class, within appropriate and proper regulatory structure. The current two-class structure limits the investment choices of average Americans and makes the pursuit of affordable retirement more difficult than it should be. The rich have a considerable example in growing assets for retirement in that they simply have more assets to begin with. They should not also have an advantage in better investment choices.
    Specifically, why should 95 percent of Americans simply because they have less than $1 million be precluded from the same choices as the rich? Why do we assume that those with less than $1 million to be sophisticated enough to understand the risk in stocks, which have lost trillions of investor dollars; stock options, the majority of which expire worthless; futures, where 95 percent of retail investors lose money; mutual funds, 80 percent of which under-perform the market; and a whole host of very high-risk investments, yet are deemed to be incapable of understanding the risk of hedge funds.
    Indeed, if hedge funds had performed as mutual funds have done in the last three years, hedge funds would be out of business. The current state of the hedge fund industry is the result of laws that were written in the 1930s and 1940s, long before anyone ever thought of a hedge fund. The path that we have come down is not one of deliberate forethought, but a response on the part of entrepreneurial investment managers to improve investment returns for clients within the current regulatory framework. It is as if we were still driving the cars of today on dirt roads built for the 1930s.
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    The first hedge fund was formed by Alfred Jones in 1952. It was a simple long-short fund, but it was revolutionary. Due to limitations imposed by Federal securities laws, the only available legal vehicle for him at that time was a private limited partnership. Thus, he was forced by the rules of decades past to not advertise or publicly solicit investors, creating the aura of secrecy. This became the pattern from which future hedge funds were cut. As an aside, hedge fund investors were subject to strict suitability requirements, thus women were the persons most often rejected as investors as they were deemed unsuitable. That was in 1969.
    The early hedge funds had a fairly limited range of strategies. As time wore on, different pioneers thought of new ways to earn absolute returns instead of the relative returns of the market. By absolute returns, I mean actual profits at the end of the day. Investors in hedge funds do not want to hear the siren song of relative returns; we are a good fund; the market is down 30 percent, and you are only down 25 percent. The reason hedge funds have grown to the extent they have done is a very simple reason. It is returns. If high net-worth investors and institutions could get the same returns as hedge funds by simply investing in stocks, bonds or mutual funds, why would they choose hedge funds which have higher fees, are hard to find and evaluate, and need more scrutiny? The answer is they would not. The demonstrably observable higher risk-adjusted returns make the effort worth it.
    Some hedge funds are very volatile and extremely risky, as are some mutual funds and stocks and futures. Some hedge funds are fairly stable and boring. Lumping all hedge fund styles into the same category can be very misleading. Simply because a person is a member of Congress does not mean they think and act alike. But just as voters get to choose the type of congressional representative they want, so too should investors be able to choose the type of funds and risks that they or their advisers feel appropriate.
    What I would suggest is that we need a new hedge fund investment company. Let me just briefly describe what that would do. A hedge fund should be allowed to register with the SEC or the CFTC as a hedge fund investment company. They would be required to have an annual independent audit, at least quarterly independent evaluations of their assets, and independent administrators, plus they would be subject to SEC or CFTC advertising rules. There would be few, if any limits on the strategies the fund could employ and they could charge a management fee and an incentive fee. They would have to fully disclose not only the relevant risk, but full disclosure of information on their strategies, personnel and management experience. As with mutual funds, there would be no limits on the number of investors. They would be allowed to advertise within current regulatory guidelines, and with certain restrictions, they should be able to take on non-accredited or average investors. Would hedge funds register under such a situation? My belief is that they will.
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Looking at the situation, we should ask ourselves three questions about opening up the hedge funds to average investors. Number one, is it appropriate? The premise of modern portfolio theory is that you should diversify your portfolio into non-correlated investment asset classes. Many hedge fund styles by any reasonable assessment are highly uncorrelated with the stock and bond markets. High net-worth individuals and institutions are taking advantage of this fact by diversifying a part of their portfolio into hedge funds. This reasonable diversification should be made available to smaller investors as well. No one would suggest that all or even a significant portion of an investor's portfolio should be in hedge funds, but a reasonable diversification is appropriate. There is no real reason to believe that smaller investors cannot understand hedge fund strategies. If investors can be assumed to understand the risk involved with individual U.S. stocks, foreign stocks, commodity futures, currencies, options, mutual funds and real estate, not to mention a host of Reg D offerings, then how could anyone suggest that hedge fund strategies are beyond the ken of investors? A hedge fund is a business generally with a straightforward premise.
    It is no more and often far less difficult to understand the risk of a hedge fund than that of a public offering of a bio-tech or a technology company.
    The second thing we need to ask, is it the right thing to do? Most hedge funds have an offshore version with lower minimums. The reality is that investors from Botswana have more and better investment choices than do U.S. citizens from Baton Rouge, Louisiana. The only people who benefit from limiting investor choices are those who have a vested interest in not facing the competition from hedge funds. As they seek to protect their turf, they have lost sight of the interests of those whom they should be serving. Those who oppose allowing average investors to have the same choices as the rich must tell us why smaller net-worth investors are less intelligent or are less deserving of options. They should show why average investors should only be allowed funds which are one-way bets on an uncertain future.
    I believe that investors would tell you that not allowing them the same choices as the rich is a kind of government protection that they do not need.
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    Finally, we need to ask, is it fair and just? It would behoove us to remember that the small investor is not even allowed a hedge fund crumb from the rich man's table. The focus of future regulation should be to make sure there is an honest game on an even playing field, not to exclude certain classes of citizens. To put it simply, it is a matter of choice, it is a matter of equal access, it is a matter of equal opportunity.
    I believe it is time to change a system where 95 percent of Americans are relegated to second-class status based solely on their income and wealth, and not on their abilities. It is wrong to deny a person equal opportunity and access to what they feel are the best managers in the world based upon old rules designed for a different time and a different purpose. I hope that someday this committee will see to it that the small investor is invited to sit at the table as equals with the rich. Thank you, Mr. Chairman. I am open for questions.

    [The prepared statement of John Mauldin can be found on page 134 in the appendix.]

    Chairman BAKER. Thank you, sir. Our next to be heard is Mr. Paul Kamenar, Senior Executive Counsel, the Washington Legal Foundation. Welcome, sir.


    Mr. KAMENAR. Thank you, Mr. Chairman. Mr. Chairman and members of the committee, my name is Paul Kamenar, Senior Executive Counsel of the Washington Legal Foundation. On behalf of our foundation, I would like to thank the chair and the committee for inviting us to testify on this important aspect of hedge fund regulation, namely the relationship between trial attorneys and short sellers. We applaud the committee and its staff for its interest in this important aspect of the hedge fund issue, and urge the committee to exercise its oversight function and ensure that the SEC addresses this issue as well.
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    Briefly, WLF is a nonprofit public interest law and policy center based here in Washington, D.C. We advocate free enterprise principles, responsible government, property rights, strong national security defense, and civil justice reform. Earlier this year, WLF launched its investor protection program to protect the stock markets from manipulation; to protect employees, consumers, pensioners and investors from stock losses caused by abusive litigation practices; to encourage congressional regulatory oversight of the conduct of the plaintiff's bar with the securities industry; and to restore investor confidence in the financial markets through regulatory and judicial reform measures.
    We also regularly oppose excessive attorneys' fees in class action cases on behalf of consumers, and we also filed comments with the SEC last week on their hedge fund roundtable.
    As part of our investor protection program, we filed a complaint with the SEC earlier this year; gave copies to the committee here and on the Senate side, as well as at the Department of Justice, calling on the commission to conduct a formal investigation into the short-selling of J.C. Penney stock that occurred shortly before and after a major class action lawsuit was filed against Eckerd Drug Stores, which is owned by J.C. Penney. We think the J.C. Penney case is just the tip of the iceberg, and is a good illustration of the problem, and therefore I would like to focus on it in my remaining time.
    Details of the questionable contacts between the lawyers and the short-sellers is recounted in a January 7 issue of the Wall Street Journal, a copy of which is appended to our written statement. The headline of that article says it all, ''Suit Batters Penney Shares, but Serves Short Sellers Well.'' In a nutshell, evidence suggests that trial attorneys may be tipping off short-sellers or hedge fund operators as to what major class action lawsuits against publicly traded companies will be filed with the court.
    Armed with this material non-public information short positions are able to be taken in the stock of the targeted company. When the suit is filed, the price of the stock in the company falls, and short-sellers stand to gain by the price drop. The U.S. Chamber of Commerce has called upon the SEC to order an informal investigation into our complaint.
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    According to the Journal article, there are plenty of questions that remain unanswered that the SEC needs to ask, and here are just a few. In the first place, it is questionable who the plaintiff was in this case. It was filed on behalf of a 77-year-old widow named Shirley Minsky of Fort Lauderdale, Florida, who alleged that Eckerd Drugs overcharged consumers for certain liquid medications. There is only one problem. Mrs. Minsky did not authorize the filing of the suit. She learned it from her next door neighbor who read the news the day after the suit was filed. The attorneys claim she authorized the suit. She angrily denied it, saying ''they made up the whole damn story.''
    The lawyers scrambled to find another lead plaintiff who was substituted for Mrs. Minsky. More troubling than the selection of the plaintiff is the sequence of events and the communications that led up to the filing of the suit. According to the Journal article, Don Reilly, an Eckerd pharmacist, had complained to Federal and State authorities that he believed Eckerd was overcharging its drugs. He was repeatedly contacted by Clifford Murray, a doctor turned analyst with the Boca Raton office of KSH Investment Group. According to Mr. Reilly, Dr. Murray contacted him some 30 to 40 times to update Mr. Reilly on the timing of the class action suit against Eckerd. According to Mr. Reilly, Dr. Murray was communicating with the lead plaintiff's attorney in the suit before it was filed. In the article, Dr. Murray's office denies that he had advance knowledge of the suit and claims he did not talk to the lead attorney until after the suit was filed. The SEC needs to find out the truth of this assertion.
    Interestingly, the lawsuit was date-stamped 3:59 p.m. on Friday, February 1, 2002, which is just one minute before the close of the market for the week. Jeff Sultan, head of the local KSH, claimed that neither he nor his firm sold Penney stock short, but when asked why in this case Dr. Murray spent so much time talking to the pharmacist and whether the broker-dealer had been advising clients to short the stock, Mr. Sultan did not respond. The SEC needs to get Mr. Sultan to respond to those questions.
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    By the time the suit was filed and amended in April, 2002, J.C. Penney stock dropped a total of 32 percent since mid-November, 2001. Short-selling activity in the stock rose 43 percent between January 15 and February 15. A subsequent investigation by the Florida Attorney General's office concluded that Eckerd did not overcharge for its drugs. We do note that the aggregate figures of the short-selling was only in a monthly report, and we think that weekly and daily reports may be better, as suggested by Representative Kelly. Indeed, the Committee on Government Operations recommended such a thing in 1991.
    Finally, we think that if the SEC says there is no violation that has occurred here, whether it is a 10b-5 under the misappropriation theory under O'Hagan, that may be fine, but it is important for the public and this committee to know that, because the next question would be whether new SEC regulations should be promulgated to curb this practice, or whether remedial legislation is warranted.
    Thank you very much, Mr. Chairman, for the opportunity to give this testimony, and I am open to any questions.

    [The prepared statement of Paul Kamenar can be found on page 88 in the appendix.]

    Chairman BAKER. Thank you, Mr. Kamenar. Our next witness is Mr. Terry F. Lenzner, Chairman, Investigative Group International. Welcome, sir.


    Mr. LENZNER. Thank you, Mr. Chairman. I appreciate the Chairman and this committee and this committee staff looking at a number of activities and issues that I believe have been flying below the regulatory radar screen to the detriment of a number of American companies.
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    These activities are abusive tactics by short-sellers, exacerbated by the lack of information on the short selling positions, which was brought up by a congresswoman earlier today, and a behind the scenes an unholy alliance we now know between the short sellers and the plaintiffs bar. The result of these activities that have not been on the radar screen is the loss of jobs, loss of value to shareholders, loss of access to the capital markets by American corporations, and overall loss to the gross national products estimated at about 2 percent for the last year. I want to quickly add that I am not against the hedge funds per se. I am simply against those funds that conduct abusive activities.
    In the past, about 15 years ago, Mr. Chairman, when I started looking at short sellers, they were using a very laborious process to put out false inflammatory information about particular companies. A few real examples; a short seller calls up the FBI, and I know the Chairman of the committee is a former FBI agent, and tells the FBI that company X is an organized crime front and is involved in money laundering. They then call the press to tell them that the FBI is investigating the company. The press then calls the FBI and the FBI can neither confirm nor deny that allegation, and the press runs with the story and damages instantaneously the reputation of that company.     I have seen examples in the past where they acted as Wall Street Journal reporters to get false information to vendors, clients, customers, and regulatory authorities that the company was about to be indicted; that the company was about to go bankrupt; the company was about to lose its permit or a major contract; again, with the intent of depressing the stock price.
    With the growth of the Internet, and the Chairman noted this earlier, and the use of pseudonyms on the Internet, there has been a virtual explosion of inexpensive instantaneous communications that have been used to damage companies' reputations and depress the stock price. One of the most dramatic examples is the CareMark Corporation where a short seller went on the Internet, posed as the Chairman of the company, predicted that the fourth quarter results were going to be 50 percent less than what the company and the street had anticipated, and the company lost $400 million in net worth in less than two weeks. And the Allied Capital case; an individual by the name of David Einhorn from Greenlight Capital gave a talk at a charity event and named Allied Capital as a company with dubious accounting.
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    The day after that, the company was hit with a deluge of lawsuits by the plaintiffs bar and the co-head of the class action became Milberg Weiss; you will hear about them later. The allegation was that the valuation of assets was over-inflated and that Arthur Andersen had at one-time been their auditor. The company fought back. They mounted a vigorous campaign.
    They fought back against the lawsuits, and very recently a judge ruled in their favor and dismissed the case on the grounds that there was simply no basis on which to infer that Allied's evaluation of its investments were in fact incorrect or inflated, and thus no basis to infer that Allied's accounting policies resulted in fraudulent over-valuation. Since Allied's actual valuation policies were public, as was all adverse information about the companies in which Allied had invested, plaintiffs have not alleged that Allied concealed any facts from its investors. I might say that the gentleman to my left, Mr. Lamont, in a public statement that I have recently seen, criticized the company for fighting back.
    My conclusion is had the company not fought back while its stock suffered, it would have been battered far worse if it had not responded, as is its right, to that attack.
    We also had another individual who comments frequently on short sellers, Herb Greenberg, Onthestreet.com, echoed Mr. Einhorn's remarks, and I do not know if Mr. Rocker shorted the stock, but Mr. Rocker owns 10 percent of Onthestreet.com, and I think at some point the SEC ought to look at whether there is any kind of communication between analysts and the short sellers.
    What is missing is the information. Companies and the public and regulatory authorities get aggregate amounts of short positions every 30 days. Recently, I was watching the Moore Corporation and on February 15 it had 900,000 shares short, and on March 15 it had 14 million shares short. No information in between, and as a result if I was Chairman or CEO of that company, I would have been alarmed when I picked up a newspaper on the 15th of March and saw that my short position had grown so immensely.
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    The other questions, I was glad to see the Chairman announce today that 13d, the 5 percent reporting requirement, does apply to short sellers, because I have asked a number of senior SEC officials and security lawyers if 13d applied and nobody seems to know. In fact, nobody seems to know why there is so little information published about the short positions. The Chairman did say 13d applied, but he said they had looked and had not seen any holdings in excess of 5 percent. The question I would suggest is, as in the long positions, has the SEC looked to see if there are concert parties, that is to say a number of short sellers who are shorting the stock at the same time in concert with each other, that exceeds 5 percent. If it does, then they do have to file under 13d. We have seen enough patterns of communications and coordination between short sellers in cases like Allied Capital to think that that does exist and the SEC ought to take a look at it.
    Now, the relationship between the plaintiffs bar and the hedge funds; you do not have to go any farther than the Hedge Fund Association. If you click on their Web site, and most of the short sellers are represented by the Hedge Fund Association, one of their members of the board of directors is Randall Steinmeyer of the Milberg Weiss firm. If you click on his name, you get instant access to the Milberg Weiss Web site. So that if you are a short seller or a plaintiff looking for a law firm, it would be very easy to find them.
Now, I just want to talk briefly about the Dynegy case, because it kind of wraps up all the issues that I have been talking about, including Mr. Steinmeyer. An individual by the name of Ted Beatty became unhappy and concerned about Dynegy's accounting practices. He thought they were wash transactions and they had a banking relationship that they called Project Alpha. He gave this information to a short seller who immediately shorted the stock. He also gave that information to the Wall Street Journal, who published an article on April 3, 2002. Unfortunately for the short sellers who had taken positions in anticipation of this article, the price went up and not down, and they panicked, and they called Mr. Beatty and said, can you give us more information to make the stock go down? He said, at this point I had been threatened with a lawsuit from the company that he had now left, and I want a lawyer. They said just give us the documents, and we will get you a lawyer, and we want you to be the front man and we want you to talk to the newspapers about Dynegy, talk to the regulators about it, and talk to the credit rating agencies about it. Indeed, he did do all of that and Moody's lowered their rating based on what he told them.
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    The next thing he heard was that Mr. Steinmeyer had been approached by the short sellers to represent Mr. Beatty. Mr. Steinmeyer called Mr. Beatty on April 15, upset, frustrated and unhappy that the Wall Street Journal had not depressed the stock, but rather the stock had gone up, and insisted as part of his legal representation that Beatty send him materials that he took from Dynegy immediately. Ultimately, Beatty did and Steinmeyer turned around and used them to file a lawsuit against Dynegy. Steinmeyer never represented Beatty, never gave him a single piece of advice, and never talked to him about any of the issues that were of concern to him.     And the stock did then decline. But when Steinmeyer, the lawyer, went to Beatty and told him, I am upset that the stock price had not fallen during that period of time, it inferred to me that Steinmeyer was working closely with the short sellers. Indeed, when Beatty told the Wall Street Journal that, that Steinmeyer had told him not only was he working closely with the short sellers, but the short sellers had made $150 million on shorting Dynegy stock between April and May, Steinmeyer called from Europe to the Beattys and said if that is printed, we no longer represent you. He was extremely upset and told them that if was off the record, when he told them about his relationship with the short sellers.
    Chairman BAKER. Can you begin to wrap up for me, sir?
    Mr. LENZNER. So in conclusion, what I am suggesting is this is a clear plan of the relationship between these two groups, whose major interest is to drive prices down. I believe if the commission and this committee looks further into this, you will see a very profound historical pattern of the same kind of activity.
Thank you.

    [The prepared statement of Terry F. Lenzer can be found on page 121 in the appendix.]

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    Chairman BAKER. Thank you, sir, for your comments. Our next witness is Mr. Owen Lamont, Associate Professor of Finance, Graduate School of Business, University of Chicago. Welcome, Mr. Lamont.


    Mr. LAMONT. Thank you, Mr. Chairman. I am pleased to have this opportunity to testify about the state of the hedge fund industry and the role of short sellers in capital markets, and I thank you, Mr. Chairman and the members of the committee, for this opportunity.
As an economist, I am concerned with prices. We need to get the prices right. To get the prices right, we need to get all information, negative and positive, into the market. When security prices are wrong, resources are wasted and investors are hurt. One way to get negative information into the market is through short sellers. Without short sellers, stock prices can be too high. Stocks can get overpriced, as only optimistic opinions are reflected in the stock price.
    Our current financial system is not set up to encourage short selling. We have well-developed institutions such as long-only mutual funds to encourage investors to go long, but we do not have many institutions to encourage them to go short. As events of the past few years have made clear, the infrastructure of our system; the analysts, the underwriters, the issuing firms, the accounting firms, and some elements of the media; have an overly optimistic bias. In addition to this optimistic bias, there are technical issues about short selling. Sometimes it is difficult to short, or impossible to short certain stocks for technical reasons. Simply put, our system is not set up to facilitate short selling.
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    A variety of evidence suggests that when stocks are difficult to short, they get overpriced. One example I have studied is battles between short sellers and firms. We have heard about some current battles. I have studied battles in history. Firms do not like it when someone shorts their stock, and sometimes they take actions against short sellers. An example is Solv-Ex, a firm that in 1996 claimed to have technology for economically extracting crude oil from tar-laden sand. In 1996, Solv-Ex took some anti-shorting actions. It attempted to organize a short squeeze, and it later filed suit against short sellers, claiming the short sellers had illegally spread false information. But in this case, it was Solv-Ex that was engaged in illegal activities, not the short sellers. Subsequent to this anti-shorting action, Solv-Ex de-listed, the SEC investigated, and the court ruled in 2000 that the firm had indeed defrauded investors.
It turns out, based on the historical record, that Solv-Ex is a typical case. The evidence shows that when you have these fights against short sellers and firms, short sellers are usually vindicated by subsequent events. Firms that take anti-shorting actions tend to have falling prices in the following years, suggesting that they were overpriced to begin with, perhaps due to fraud by management; perhaps just due to excessively optimistic investor expectations.
    Short sellers are good at detecting and publicizing fraud on the part of firms. Again, recent events of the past few years have shown that we need more whistleblowers and we need to encourage people to be whistleblowers. The SEC and the regulators cannot be our only line of defense against corporate fraud. To protect investors, we need a vibrant short selling community.
    Even absent corporate fraud, though, short sellers play an important role in protecting individual investors from overpriced stocks. When informed traders are not able to go short, it will tend to be the small investors who unwittingly buy the overpriced stocks and the smart money stays away. For example, during the tech stock mania in 2000, there were some stocks that were identifiably overpriced, but they were not shortable for technical reasons. The victims in this case were the individual investors who bought those stocks and later suffered substantial losses.
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    In my opinion, therefore, we should change the current lopsided system which discourages short selling. First, in the narrow technical arena, we need to find ways to make the equity lending system work better. It seems particularly unhelpful that firms are sometimes able to abuse various aspects of the system in order to prevent short selling. Second, in the broader arena, we need to continue to encourage the development of institutions that channel investor capital into short selling. It would benefit both the efficiency of prices and the welfare of investors if more capital were allocated to strategies involving short selling; for example market-neutral long-short funds. This goal could be accomplished through increased investment in hedge funds, retailization of hedge funds, or it could be accomplished through mutual funds that employ long-short strategies.
    What we should avoid is a set of new regulations that limit the freedom of hedge funds to exploit and correct mis-pricing. I fear that such new regulation might have the unintended consequence of making short selling harder than it already is. There is a natural tendency to feel that short selling is somehow inherently malevolent and un-American. To the contrary, nothing is more beneficial to our economy than detecting fraud and correcting overpricing. If we are going to have liquid markets that properly reflect available information, investors must be able to both buy and sell.
    Of course, it is appropriate for the SEC and other authorities to investigate possible cases of market manipulation, but the big story of the past few years has been malfeasance on the part of the long side; the issuing firms, the analysts, the accounting firms, and the underwriters. The short sellers have been the heroes of the past few years, alerting the public and the authorities to corporate fraud.
    Congress and the SEC will continue to hear complaints about short selling from firms, and we have heard some today. As I mentioned earlier, the evidence shows that when companies and short sellers fight, it is the short sellers who are usually vindicated by subsequent events. For example, in 1989 before this House, the House Committee on Government Operations, the Commerce, Consumer and Monetary Affairs Subcommittee, held hearings about the alleged evils of short selling featuring testimony from supposedly victimized firms. Officials from three firms testified. Subsequent to this testimony, the Presidents of two out of these three firms were charged with fraud by the SEC. So when you hear companies complain, keep in mind that short sellers are often the good guys.
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    Thank you for this opportunity to testify, and I would be delighted to answer any questions.

    [The prepared statement of Owen Lamont can be found on page 109 in the appendix.]

    Chairman BAKER. Thank you, Mr. Lamont. Our last panelist today is Mr. David A. Rocker, General Partner, Rocker Partners. Welcome, sir


    Mr. ROCKER. Thank you, sir. I am honored to have this opportunity to address the House Subcommittee on Capital Markets to offer my views on hedge funds, short selling, and the appropriateness, of additional regulation.
    Rocker Partners is an 18-year-old firm with a contrarian style. While we maintain both long and short positions, we have focused our research efforts most heavily in recent years on short selling because we have identified more stocks which we have felt were overvalued than those which we felt were attractive. We are generally viewed as a specialized manager, and our investors, primarily wealthy families and individuals and institutions such as universities, hospitals and endowments, often use us as a risk-reducing hedge against their long-biased investments.
    Hedge funds have grown rapidly because they have served both of their constituencies, investors and their managers, better than more conventional alternatives. Over the last six years, which encompassed both the expansion of the biggest equity bubble this country has ever seen, and its subsequent deflation, an investment in the average-performing mutual fund would have remained essentially unchanged, but the same investment in the average-performing hedge fund would have appreciated approximately 75 percent, and would have done so with lesser volatility.
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    Investors have also been attracted to hedge funds because of the greater identity of interests between the fund manager and the investor. Substantial personal assets of the hedge fund manager and their families are typically co-invested alongside limited partners, and such investments typically represent a much higher percentage of total assets under management than is the case in mutual funds.
    Hedge funds frequently provide a more attractive financial opportunity for successful managers, and a broader investment flexibility available in the hedge fund structure has also proven appealing. As a result, many former mutual fund managers have joined or started hedge funds in recent years. While there is considerable discussion as to whether hedge funds require greater regulation, it is important to recognize that even unregulated funds are already subject to a substantial degree of oversight.
    Sophisticated investors, especially in mature funds such as ours, impose tremendous demands on managers with whom they choose to invest, including among other things that the fund has formal compliance policies, appropriate restrictions on employee trading, investment transparency, operational efficiency, risk management techniques and a host of other protective requirements. Those managers that do not or cannot provide these protections to the investor marketplace generally do not succeed or survive. There are lots of choices. Additionally, the co-investment of the hedge fund manager's personal and family assets help serve as a self-governing mechanism.
    The highly publicized hedge fund blowups in recent years must be placed in perspective. Such funds have represented fewer than one-quarter of one percent of the industry, and the superior investment results cited earlier include the losses from these entities. As the present structure has served investors well during both rising and falling markets, I believe that additional regulation is neither necessary nor desirable. Existing regulations effectively applied, coupled with the extensive due diligence and operational requirements of investors, have proven sufficient to date. Anyone willing to commit fraud will not be deterred from doing so by a registration statement. With few notable exceptions, hedge funds have proven less risky, so the present focus on them in this context is somewhat puzzling.
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    I am not going to comment on retailization, as it is not an area of expertise and time is short. I would like now to turn my attention to short selling and the important role I believe it plays in creating more liquid, balanced and fair markets. Short sellers already operate in a field tilted sharply against them, and considerable restrictions and risks relate specifically and often uniquely to this strategy.     Unlike a long investor who can buy a stock at any price or repeatedly at ever-higher prices intra-day, the short seller must initiate his or her position only on an uptick; a price above the preceding trading price. Buyers do not have to wait for downticks.
In contrast to a long position, in which only the initial investment can be lost, there is a risk of potentially unlimited loss in short positions. The short seller is obligated to pay dividends to the holder from whom he borrows stock, and most especially there is the potential loss of one's ability to determine when a short position is purchased or covered. If the supply of borrowable stock dries up, the short seller may be involuntarily bought in by his broker in what is generally known as a short squeeze.
    The short seller has no control over when the stock is bought in or the price at which it is executed. The situation is clearly distinct from that of the long holder, who cannot be forced into an involuntary sale.
    The contribution of the short seller to more efficient markets can be best evaluated in the context of the stock market in the last six years. An equity bubble of extraordinary proportions developed in the late 1990s, peaking in early 2000. The Internet mania was just the most visible part of this general hysteria. Since the peak, the bubble has deflated, costing investors some $7 trillion. By the way, I would encourage you to read an article that I wrote for Barron's ''A Crowded Trade,'' which is part of the package that I included, and it covers some of the structural issues that have made it so.
    The goal of regulatory policy must be to establish fair and safe markets for investors. In considering what if any regulatory changes are appropriate, I believe it is important to reflect on the forces that created the bubble, as well as those which have led to its demise. In that connection, it is important to understand the structural bullish bias of the market. Shareholders, of course, want their stocks rising. Corporate officers desire higher prices, as this serves both as their report card and, thanks to the liberal use of options which should be treated as expenses, the key to enormous personal wealth. Higher stock prices also provide inexpensive acquisition currency. Security analysts clearly want stocks higher to validate their recommendations. For every transaction, there must be both a seller and a buyer.
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    Thus, it is interesting to note that while 50 percent of stock transactions are, by definition, sales, purchase recommendations by analysts are 10 to 20 times more numerous than sale recommendations.
The recent Wall Street settlement has focused on the pressure placed on analysts from internal investment banking. The pressures from clients and corporate executives have received much less attention. Analysts who recommend the sale of stock risk the ire of the clients who own it. These clients complain to research directors, and can withhold favorable votes and reviews important to an analyst's compensation.
    Similarly, corporate executives frequently react in a hostile manner to anyone who downgrades their stock, restricting his or her contact with the company and thereby making future analysis of the company more difficult.
    Collectively, these factors, coupled with a cheerleading media, created the bubble. Anyone challenging the valuation of a company or the integrity of its financial statements was most unwelcome in this environment. Analysts and market strategists who either warned of overvaluation or were insufficiently bullish were pushed aside and replaced by those who went along with the irrational exuberance.
    Short sellers, through their research and public skepticism, provide a much-needed counterpoint to the bullish bias. They are willing to ask touch questions of management in meetings and on conference calls, thereby providing a more balanced view for listeners. Investors benefit by getting both sides of the story when the views of short sellers appear in the media. Several articles I have written are enclosed as part of this presentation.
    Short sellers have helped uncover many frauds and accounting abuses in recent years, including Tyco, Enron, Conseco, AOL, Boston Chicken, Network Associates and Lernout and Hauspie, among a host of others. Short sellers serve as unpaid, albeit self-interested, detectives who willingly share their findings with the SEC, which has acknowledged the usefulness of these inputs. Although there have been occasional instances in which short sellers have been accused of circulating misleading stories, these instances are dwarfed both in number and magnitude by the misleading stories circulated by long holders and the issuers themselves. Because of the greater risk in short selling, research done by short sellers has tended to be more careful and more accurate than most.
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    As Gretchen Morgenson of the New York Times recently reported, and I quote, ''if you own shares in a company that declares war on short sellers, there is only one thing to do: sell your stake. That is the message of a new study by Owen Lamont, associate professor of finance at the University of Chicago's graduate school of business. That study, which covers 1977 to 2002, shows not only that the stocks of companies who try to thwart short sellers are generally overpriced, but often that the short sellers are dead right.''
    The value of short selling as a means for creating greater liquidity and orderly markets is well understood. Specialists of the major exchanges are required to sell short to help offset an imbalance of orders. Trading desks at brokerage firms do so as well to facilitate customer orders. It is also important to note that over two-thirds of short selling is simply related to arbitrage activities.     So when you see the short interest figures in the papers, it is important to put them in this context.
    Any effort to further restrict short selling should be rejected. While short sellers seem to attract a disproportionate amount of attention, usually from companies with questionable accounting or flawed business models who do not welcome scrutiny, the number of short biased firms are few in number and are actually shrinking. Many short sellers were driven out of business during the bubble, and even today they represent the only sub-category of hedge funds that has seen net redemptions in recent years. Of nearly 6,000 hedge funds, short biased hedge funds with asset bases of $100 million or more number fewer than 10; 10 out of 6,000; and the total assets managed by these entities is well under 1 percent of the total assets managed by all hedge funds. That few managers have chosen this strategy or have been able to survive suggests that there are easier ways to make a living.
    The short interest in each stock is reported monthly, yet there are proposals circulating, most visibly from the Full Disclosure Coalition now in formation, by the Washington law firm Patton Boggs, which would seek to have individual short sellers detail their short positions in periodic filings. The claim being made is that this would level the playing field, but as we discussed earlier, the playing field is already tilted sharply against the short seller. Such disclosure requirements would serve only to make targets of individual short sellers and likely drive them out of business. Some publications are designed specifically for the purpose of creating short squeezes which can be exploited by traders and mutual funds who know that short sellers cannot defend themselves from escalating prices by selling on downticks. Most companies simply ignore short sellers, recognizing that there are differences of opinion in free markets, and go about their business.
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    Chairman BAKER. Can you wrap up?
    Mr. ROCKER. In light of Mr. Lamont's findings, it is interesting to see which companies will be part of this coalition. I am just about finished.
    The reason the Williams Act requires the filing of a 13D is to alert a company that someone is accumulating more than 5 percent of their shares and may be attempting a creeping tender. There is no such threat from a short position, as being short does not give anyone any vote or any authority whatsoever.
    Given the positive contribution by short sellers and the evident shrinkage in their number, it is hoped that consideration should be given to truly leveling the playing field by modifying the uptick rule to make is less restrictive. This would contribute to greater stability in today's electronically-driven markets. Short selling plays an important role in public capital markets. Any additional bias in favor of long investors will further erode this important counterweight. Short selling is an important investment tool as part of a proper risk reduction investment strategy. The marketplace not only understands the benefit of short selling, in fact it requires it. I thank you for your time and your attention. I would be happy to answer questions.

    [The prepared statement of David A. Rocker can be found on page 159 in the appendix.]

    Chairman BAKER. Thank you, sir. Mr. Lamont and Mr. Rocker, from your testimony it would appear that you view the short selling world different and distinctly in character from that of the equity side. Is it not sort of a logical thing that you follow the money; that when the analysts were trumpeting the longside to drive prices up, there was a reason for that. Is it your view that the same manipulative forces do not work on the short side of the ledger as well? That reporting of information adverse to a corporate outlook has financial consequences of value to those engaged in that activity.
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    Let me characterize the question properly. I see extraordinary value in short selling. I think it performs a market function that we should foster and encourage, but the reasons for the disparity in reporting of the historic misconduct is a democratization on the side of equities, with the limitations on the number of people who can successfully participate in the hedge fund activity, and a view by some that if rich people lose money, so what. So the Chairman appeared here today of the SEC and indicated we do not even know how many of these funds there are, much less what they are doing. In the absence of that information, how can we then draw the conclusion that one side is good and the other is bad. Can you respond to that?
    Mr. LAMONT. As a theoretical matter, of course, you might expect manipulation to take place on the long side and the short side. Certainly, there is manipulation that takes place on the short side, it is just rare given that so few people ever short and it is so hard to short, and given that the firms really control information; you know, if you are Enron you control the flow of information going out of Enron. Historically, it has been the long side that has done the manipulation and has done the fraud.
    Chairman BAKER. But that has been the result of expectations by the broad consumer group wanting to get in on what was perceived to be the 15 to 20 percent rate of return. You threw money and did not ask the questions. That was because it was open to the smallest of investor and the lowest dollar denomination possible. Whereas on the other side, it is a much more restrictive world in which the losers are folks of considerable assets, generally speaking. So I am just trying to frame it. You may be absolutely right, but it would appear on the statistical data available we have not sufficient sampling on the short side to really know how equitably or efficiently it works as related to the volume of information available on the long side. Is that fair?
    Mr. LAMONT. You are thinking about manipulation, right?
    Chairman BAKER. Those activities which are not conducive to good public policy.
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    Mr. LAMONT. The SEC and the other regulatory bodies, the NYSE and the NASD, do have full powers; they have the power to investigate manipulation and they do investigate manipulation on the short side. As Mr. Rocker mentioned, there are all kinds of limitations. There are many extra limitations on short selling that are not true on going long.
    Chairman BAKER. On overt misrepresentation of fact or manipulation of corporate performance which is known not to be accurate, certainly. I think the Chairman spoke rather at length this morning, though, to the veil that appears to be between him and his agency and understanding what really is happening in that sector of the market. I am not picking arbitrarily on you two guys, but we do not have enough information, at least in my perspective, to make those absolute clear determinations between the two sectors of the market. I think both are extraordinarily important for our overall economic vitality.
    Let me jump to the other side, because we have been here awhile, and I certainly want to get to Mr. Kanjorski as well. Mr. Mauldin, following your logic about the openness of the market to all who choose to come, that would lead me to the next question. What about suitability requirements period? I mean, why don't we let everybody; the young person cutting grass for three bucks an hour; invest his money wherever he sees fit. Is that the logical end conclusion of not having some criteria for investing?
    Mr. MAULDIN. The answer is yes. But under the framework that I am proposing, and I have got it in my written statement, what I would suggest is that opening up hedge funds to the average investor does pose some risks. The primary risk that it poses is that investors look at the great returns and jump into the funds not understanding and having no background for that.
    I think there ought to be a period of about seven to ten years where average investors could only invest in this new hedge fund investment company if they passed some program showing that they were suitable; showing that they could understand hedge funds; or if they went through a broker or an investment adviser who passed appropriate tests showing that they understood hedge funds. So you give that seven to ten year period to allow investors to begin to get used to the different types of risk that hedge funds pose.
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    It is not a matter of risk or no risk. Every market has risk. It is just you get to choose which risk you want. So as investors become aware of it and understand those risks, they say yes, I want that risk as opposed to the risk in stocks or bonds.
    Chairman BAKER. So you would suggest we proceed, but proceed with caution.
    Mr. MAULDIN. Absolutely. Hedge funds are not investment nirvana. They have got all sorts of risks. I spend a great portion of my day every day investigating hedge funds trying to find out where the risks are. Some of them are very scary. I would not for a minute suggest that they are not. But you choose your risk. That is why investors now have a 401k that is a 201K. They had very limited options.
    Chairman BAKER. We have a dilemma in the sense that hedge fund information is generally deemed as proprietary, and if we disclose what we do our competitors will then encroach on our market diminishing our profitability.
    Mr. MAULDIN. I am sorry to interrupt, but I think that is kind of a false idea. It is amazing how much information; you can go on my Web site. I have got a due diligence document with well over 100 questions that I ask a hedge fund when I go in. It is amazing what they will tell you.
    Chairman BAKER. But it is also amazing what they won't. LTCM said give me a million dollars and go away for a few years and do not call me.
    Mr. MAULDIN. If you invested in LTCM, you got what you deserved.
    Chairman BAKER. Yes, but you could not get behind the screen to determine what you were buying.
    Mr. MAULDIN. But the point is that under a hedge fund investment company that I would open up to the public, you do not allow companies that do not open up in. You require the disclosures. You require the transparency.
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    Chairman BAKER. Even sophisticated lenders; insured depositories; were throwing money at them because they had three years of back-to-back successful investment activities without a two-day back-to-back trading loss until the demise.
    Mr. MAULDIN. Let us look at what happened to Long-Term Capital. You had very smart managers who took highly concentrated positions in markets that they could not easily exit. That is the same thing that happened in the mutual fund Janus 20, where investors lost $10 billion as they had technology stocks that they could not get out of. It is not a matter of risk or no risk. It is a matter of choosing your risk. You still have to have transparency and disclosure; you absolutely have to have that.
    Chairman BAKER. I am not disagreeing with you. I am pressing you because it just begs the question perhaps, but it is alright for everyone to defend their home; it is another thing to give a loaded hand-gun to a six-year-old. I think that is where we are trying to balance the equities. When do you understand the risk you are taking, and when is it advisable for us to require more information to be made available so that an educated person can take the risk that is advisable for them?
    Mr. MAULDIN. I think that part of the cure here is to require disclosure and to require more information. I would do that within the context of the hedge fund investment company. You allow the hedge funds to disclose. Here is what we do. Most hedge funds, they are businesses. They have very straightforward premises; we do this; we are seeking this type of return; and this is the way we go about it. It is not more difficult to understand than a Cisco or a General Motors or a GE.
    You just simply give the investors, the individuals the opportunity. To simply say that somebody; I mean, I have people who have MBAs in finance. I cannot tell them about hedge funds because they do not have $1 million. Most of the members of this committee, I could not talk to you about the hedge funds that you are overseeing because the laws say that I am not allowed to tell you about these funds because you are not sophisticated enough. These are very strange rules.
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    Chairman BAKER. But I agree with that rule.
    Mr. Kanjorski?
    Mr. KANJORSKI. You can tell us about it. We just cannot engage in it.
    Mr. MAULDIN. I cannot. No, sir.
    Mr. KANJORSKI. You mean you cannot even tell me what you do?
    Mr. MAULDIN. I can tell you what I do, but I cannot talk to you about a specific fund.
    Mr. KANJORSKI. No, not to recommend that we get into it because I am not a qualified investor.
    Mr. MAULDIN. I am not even supposed to discuss a specific fund or a specific investment with somebody who is not an accredited investor, and not deemed suitable for that investment.
    Mr. KANJORSKI. Yes, carrying your logic to a further extent, maybe this committee should pass a law barring Bill Bennett from casinos.
    Mr. MAULDIN. It could happen.
    Mr. KANJORSKI. The question I have, we are not in the business of guaranteeing people a return or protection on their investment. We should be in the business of making sure there is not fraud and abuse.
    Mr. MAULDIN. Absolutely.
    Mr. KANJORSKI. And that hopefully opening up markets to qualified individuals, but this whole idea of giving a test; are you serious? I mean, you don't give anybody a test when they walk into a casino, and yet 90 percent of them lose money when they walk into a casino. I have sat at card tables and have been absolutely awed when people will split two tens. Any book you read on it will mathematically tell you that is a stupid bet, but people have a right to make a stupid bet. People have the right to buy stupid things.
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    Mr. MAULDIN. If this committee decided that we should open up the investment world and wanted to allow anybody in without having some deemed suitability, that would be the committee's decision. There are a number of courses that are offered by independent academic institutions that would prepare somebody to be able to analyze the risk in hedge funds. I personally think they should do that before they buy stocks, but that is a different story.
    Mr. KANJORSKI. Going to the retailization of this whole thing; isn't there enough money in the hedge funds now, $650 billion, a growth of 10 times in 10 years? Isn't that enough money? Why are we worried about encouraging or opening the market to more people or more money?
    Mr. MAULDIN. It is not about how much money is in the hedge funds. It is about the fairness of the situation. This is all a matter of equity. Why should a rich person have an advantage that a less-richer person does not? Why do the rich get the best deals?
    Mr. KANJORSKI. Rich people who derive their riches from financial transactions are usually smarter people, too, aren't they? I mean, there is some correlation there.
    Mr. MAULDIN. I deal with a lot of those people and I am not certain that is true; except for my clients, of course.
    Mr. KANJORSKI. It may not be true, but they are rich enough to pay the tuition to lose.
    Mr. MAULDIN. That is correct. Investors are rich enough to pay a tuition to get in their 401K and put it in an index fund that drops 40 percent.
    Mr. KANJORSKI. From the experiences I have heard before this committee for the last several years, all of us seem to brag about how many more people are in the equity markets. I am not certain that that is something we should be bragging about. I am not certain that more than 50 percent of the people have the financial sophistication to be in the equity markets. But I am not going to bar them from being there. I think that is the marketplace. They lose, that is their tuition.
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    Hopefully they are smart enough that they only have to lose one time. But if they want to play, I do not see the role of government in all these things. What is our role that we have to force very sophisticated organizations that have put together a program to invest, and now we have got to force them to tell the whole world what; I think that is what the Chairman was getting at; what their thought process is and what they are going to do and how they are going to it, so that their competitor can read that. Is that our system?
    Mr. MAULDIN. That is not what I am suggesting. I am saying that this is a voluntary thing. You would not require every hedge fund to register. You would offer hedge funds that would like to broaden their base the opportunity to register. I do not want to disturb the status quo. I want to create a new hedge fund investment company.
    Mr. KANJORSKI. I would suggest then the very sharp hedge funds. They probably do not have a heck of a lot of difficulty attracting capital if they are making a lot of money and they have a long history record of being successful. I imagine people are knocking on their doors hoping to qualify and let them take their money and invest it and get a high return. Why are we so interested in putting this in a retail business to suggest that we want to bring a lot more money into hedge funds, and why do we want to get a lot more less sophisticated people into hedge funds as a government policy? I do not see that is our role. I would rather build fences from people jumping over cliffs, rather than paving roads to cliffs.
    Mr. MAULDIN. I still think is comes back to an issue of fairness. Hedge funds have clearly out-performed mutual fund stocks. There is no question about that. Why should a smaller investor simply because he does not have $1 million, and the real practical limit is $4 million to $5 million; it is not $1 million; why should smaller investors be prevented from sitting at the same table as a rich person? Why shouldn't they have access to the best managers in the world?
    Mr. KANJORSKI. Well, I just came back from my office and I read a scam where eight of my constituents were scammed out of about $1.2 million. When you read the scam, and you read the level of sophistication of these people, you have no wonder why they were scammed. To encourage them into what I would think is the Ph.D area of investment, with the idea that instead of getting a sounder return on a safer investment, they are going to go out seeking the higher return with the idea that these people; hedge funds do lose money, don't they?
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    Mr. MAULDIN. Hedge funds do lose money.
    Mr. KANJORSKI. Some very wealthy people sometimes lose a lot of money? They are not guaranteed to make money.
    Mr. MAULDIN. That is correct, but I think here again you have the assumption that all hedge funds are equal. We have lumped them into the same class. Some hedge fund are very, very boring, very, very stable. My favorite styles of hedge funds invest in bonds, and they have been able to take out the direction risk of bonds and give their investors very stable returns. You invest in them not because you want to shoot the moon or you are wanting 15 or 20 percent, but because you want a steady 7 or 8 percent. Why shouldn't investors be allowed to do that?
    Mr. KANJORSKI. I am not sure it is the role of government to make everything fall under the rule of egalitarianism. I do not recognize that as a capitalistic concept. Generally, capitalism is winners and losers and people that are shrewder make shrewder investments, and they prove their way into the market. I certainly do not want to encourage middle class average families betting their retirement or their kids' funds on a hedge fund because they can get 5 percent more return on their money, possibly. I am not sure that is good public policy.
    Mr. MAULDIN. I would reply that the government is already involved. It is involved because it has excluded people from the table. And the second thing is, all the academic studies show that the choices that mom and pop have today for their children's education funds are much riskier than hedge funds. So you are only giving your constituents and voters; you are giving them choices of more risky things. By opening them up to some of the hedge fund strategies that are available to the rich, you would actually be helping them improve their retirements and their college education funds. Right now, they have bad choices.
    Mr. KANJORSKI. You would recommend if there is ever a success in privatizing Social Security, we allow these Social Security people to take some of their money and put it in hedge funds?
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    Mr. MAULDIN. If you privatize it and you would allow them to put their money in stocks or bonds or international stocks, then hedge funds would be appropriate.
    Mr. KANJORSKI. So stocks or bonds are riskier than hedge funds? Is that your view?
    Mr. MAULDIN. Clearly. Absolutely. I presented the evidence in my statement. We compared bond funds to hedge fund strategies. Again, you have got to be careful when you say ''hedge funds.'' There are dozens of different styles of hedge funds, and some of them are very risky and I would not put French money into them. Some of them are very, very stable, well managed, well run funds.
    Mr. KANJORSKI. We just had the commissioner tell us he is not sure he is going to be able to define what a hedge fund is.
    Mr. MAULDIN. That is a very good point.
    Mr. KANJORSKI. If you are going to have a hard time defining it, we are going to have a hard time keeping people in or out of whatever these 6,000 or 7,000 entities are. Until we can define it, it seems to me we are not in a very strong position to be able to regulate it in a reliable way. Just to open them up for the benefit of allowing middle class people to make a little bit more money; never become wealthy, but make a little bit more money, contingent with how that may be on also losing a great deal more money, I think it is a tough proposition. We have some folks here who are opposed apparently even to short selling. That is too risky.
    Mr. MAULDIN. I think short selling is a very risky proposition. Mr. Rocker, I think, will tell you so.
    Mr. KANJORSKI. Well, it is risky, but does the government belong in the world of saying you cannot do a risky thing? I mean, it is risky for someone to take a cruise on a cruise liner who cannot swim, but that is not for us to say you have got to administer a test after you buy your ticket and prove you can swim in case the liner goes down. That is a risk of life. They have to be smart enough to protect themselves. Other than that, we are going to have to hire an awful lot of government people to walk around holding the hands of other people who do not want to feel that they have to make these decisions themselves; that it is up to the government to guide them along the way to success or life.
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    Mr. LENZNER. We are not saying we want to eliminate short selling. That is not even on the agenda. What we are saying is that there has been a history and a pattern and practice of abuses in the short selling industry, combined with their alliance and working with the plaintiffs bar, which has damaged——
    Mr. KANJORSKI. Do you have very clear evidence of that?
    Mr. LENZNER. Yes, sir. We have very clear evidence. We have several cases.
    Mr. KANJORSKI. How many plaintiffs bar have been disbarred because of that conspiratorial action?
    Mr. LENZNER. The plaintiffs bar firm I am talking about today is currently under Federal investigation in the Los Angeles U.S. Attorney's office.
    Mr. KANJORSKI. I would imagine anybody who made a statement that there may be a conspiracy would cause a Federal investigation. Investigations do not amount to anything unless there is an indictment and conviction.
    Mr. LENZNER. Yes, right, and they are still investigating it.
    Mr. KANJORSKI. Yes, but don't hold up because, quote, they are being investigated. Hell, we investigate all kinds of things here. I would hate to conclude that everyone we talk about or investigate is guilty of something improper, wrong, immoral or illegal. That is not the case.
    Mr. LENZNER. This practice conducted by the short sellers with the plaintiffs bar has flown under the radar screen. There are only monthly aggregate reports so people do not know exactly what they are doing.
    Mr. KANJORSKI. You mean the exchanges and the regulators do not have the authority to examine?
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    Mr. LENZNER. Of course they do, but my opening statement was this process, these activities have flown under their regulatory radar screen.
    Mr. KANJORSKI. Well, you are here now. You are in the public. You are on the record. You have a Congressional Record you can send to the New York Stock Exchange and say here is the testimony I have given. I have incontrovertible evidence. I am available as a witness to testify. I am sure there are some Attorneys General at the State level or at the Federal level that are anxious to make a reputation.
    Mr. LENZNER. I hope that is right. I was appearing here hoping to get the interest of the committee to have an oversight relationship with the SEC on this issue because it has gone below the radar screen so long, and because there are numbers of American companies who have been very seriously damaged by misinformation being put out about the company, followed up by litigation which generally can be successful or not successful. I am not defending the companies that have been talked about before; Tyco and WorldCom.
    I am talking about companies that are generally not given information about the short sellers except on a monthly basis. They are under short attack. They are not aware of it. They are not aware of information being put out, and they are not aware that the information may be coming from inside their own corporation that is being disseminated outside. So my question for the SEC is, if a short seller is gathering information from a current employee and the information is material and non-public, is that a violation of the inside information rule? I have talked to several senior SEC lawyers.
    Mr. KANJORSKI. Is it correct information? Is it true?
    Mr. LENZNER. Some of it could be true. Some of it——
    Mr. KANJORSKI. Now we are getting very close to First Amendment and privacy rights and everything. I am not sure——
    Mr. LENZNER. I do not understand that, congressman. If it is a tip from inside the corporation, it is material non-public information, why isn't that inside information being used to trade and is in violation of——
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    Mr. KANJORSKI. That is part of the free market methodology of cleaning our markets in a way. I mean, we cannot depend that government or regulators are always going to be able to keep everybody on the top and narrow. But if there is a company out there that is claiming it has product in warehouses and they are empty warehouses, and one of their inside people tells somebody, that is the market and will penalize that company dearly. I am not sure that I would like to go and say no, we are going to penalize the insider information and we are going to allow that company to continue to have warehouses that have no product that they are representing as product.
    You tell which is worse. I think having companies that have a gag rule on everything and can perpetuate all kinds of frauds would be worse than having a short selling operation; I think you have to worry. If you are a CEO and you are pulling some gimmick, you better be darn certain how few people know about it. If enough people know about it in your company and it is going to leak out, and you are going to get raided in a short sale, that is your problem. That is good enforcement. That is the capitalist market. You got stuck. We did not have to spend one cent for a prosecutor. We did not have to send the FBI down. We did not have to do anything. You just got cleaned.
    Mr. LENZNER. What is the difference between that and the investigation of Martha Stewart for when she was on a long position selling because she has heard the stock is going down?
    Mr. KANJORSKI. I do not have a lot of sympathy for the crucifixion of Martha Stewart.
    Mr. LENZNER. I am just saying, what is the difference between investigating her for that and investigating a short seller who does exactly the same thing?
    Mr. KANJORSKI. I doubt very seriously if her name were not Martha Stewart there would have ever been an investigation.
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    Mr. LENZNER. All I am trying to do is show an example of an investigation into somebody who traded on a long position; why should that be any different than somebody who traded on a short position?
    Mr. KANJORSKI. It should not be any different, but unfortunately if you are; who is that crazy guy Jackson; you know, you just have to do a crazy thing and put a mask on and you make headlines. If I did the same thing he did the other day, nobody would pay any attention to it. That is just; we cannot get into regulating and controlling that. I hope we do not, because we are going to need so many people working down at the SEC there are going to be more employees at the SEC than there are investors.
    Chairman BAKER. Let me jump in. Let me try to put all of this into a basket and I will recognize you. I think it is clear from the comments of the Chairman this morning, of the SEC, we are operating in a fashion that is clearly handicapped. We do not have enough information, I do not think, to make decisive determinations about, one, whether additional disclosure should be required; whether the regulatory environment is or is not adequate; whether or not there are manipulative forces at work on this side of the ledger. We have not as a committee ever examined this subject before. Today's hearing is not to reach an end determination, but to begin a lengthy process of examination. While we await the SEC's initial report, hopefully either before or just after the August recess, at which time I think we need to really delve into the issue of separating the hedge funds from the hedge hogs. That is what this is all about.
    There has been an enormous growth in the market. There are significant growth in resources being invested. And there are pension funds pouring money into these activities, which appear to be somewhat veiled and if not transparent, they may be translucent even to the smart, sophisticated investor, and we have work to do. I do not dispute at all what Mr. Kanjorski is saying. We do not want to be in the business of running hedge funds as a SEC or as a Congress for sure. There is a vital role for them, but we would have some action for our own constituents to look at us rather caustically if we were not to conduct this examination, given the enormity of their appearance in the marketplace.
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Yes, Mr. Rocker?
    Mr. ROCKER. Yes, I would just like to say a couple of things. The growth of hedge funds is not something that is stimulated by hedge funds seeking clients, but conversely by clients seeking hedge funds.
    Chairman BAKER. You make my point, and that was the same reason for the growth in the equity market. It was not the fact that the equity people were out there necessarily dialing up everybody. You had lots of folks with cash in the bank or even worse, borrowing money at 8 percent and investing it because they did not want to miss the 20 percent rise.
    Mr. ROCKER. That is right.
    Chairman BAKER. What we want to ensure is that we have enough knowledge that that same effect is in fact not occurring on the other side of the ledger sheet.
    Mr. ROCKER. Right. I do want to state for the record that there are a lot of things which are not subject to conjecture, but are empirical fact. Hedge funds have out-performed mutual funds. They have been more safe. They have in fact on a collective basis had much lower volatility, and so perhaps the smaller investor should have an opportunity to invest in hedge funds in an appropriately regulated fashion, if that is Congress' will. But there is not an issue of how they performed. Number two, with respect to longs spreading false rumors versus shorts spreading false rumors——
    Chairman BAKER. Let me jump back to that first conclusion. There is no question that hedge funds are functioning properly. In a broad, categorical statement, yes; as hedge fund to hedge fund, there may be questions.
    Mr. ROCKER. For sure. But as far as not knowing what the industry is or its size, there are large indices. For instance, CS FirstBoston Tremont has an index which covers about 80 percent of the assets. Those are where the statistics are coming from. So you may miss a little, but you certainly know what is happening with most. It is as good as the Investment Institute.
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    Shorts are a convenient scapegoat after a market has cost investors $7 trillion. The point that I was trying to make in my statement, and I wish to reiterate now, is that we should be looking at what got us to the level from which people lost so much money. The biases are entirely on the side of the bulls. Regulations are in place which allow any fraudulent activity, whether it be by a short seller or long, to be subject to prosecution. They should be aggressively pursued. But the record is clear, the prosecutions and more importantly the findings of such has overwhelmingly been on the side of longs pushing bogus stocks as opposed to shorts spreading bad stories.
    I would invite anybody who doubts this to look on the Web sites and chat boards of the Street to find people who are hiding behind anonymous names who, by the way, include corporate officers spreading positive stories about their own stocks. It is a wholly biased field. To the extent that you further restrict the very few people who are willing to go at risk, the short sellers, with their own capital, I believe you would be making a great mistake and risking the public savings of this nation to a greater degree.
    Chairman BAKER. Thank you, Mr. Rocker. Mr. Kamenar?
    Mr. KAMENAR. Mr. Chairman, I just wanted to make a point about the transparency issue that was raised about information. I think we all agree that transparency is a good thing. In 1991, the House Government Operations Committee, as I stated in my written testimony, recommended that daily and weekly short selling data activity and interest be obtained from broker dealers and be made available electronically; daily and weekly activity at a minimum.     This is in 1991 that the Government Operations Committee recommended that. Yet today, it is a 30-day or monthly report, and during that monthly period, as Mr. Lenzner testified, a lot of short activity could be going on that the CEO or the company and other investors do not know about. The committee also issued a report in 1991 on short selling and agreed that the SEC's uptick rule was valuable as a price stabilizing force, and encouraged Nasdaq to adopt a similar restriction, which they did in 1994.
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    So there are certain things that the committee and the Congress can do that assists investors to stabilize the market without necessarily being the nanny state for certain unsophisticated investors.
    Mr. ROCKER. That is all part of the asymmetry of the market. There is an uptick rule preventing sellers from selling it down. There is not a downtick rule preventing buyers from cascading stocks up, especially in today's electronic marketplaces where you can use ECNs to sweep markets at various levels. That is what got stocks to 130 times earnings for the Nasdaq 100. That is when the mutual funds were sucking in a tremendous amount of the savings of this nation which was subsequently destroyed. That is what should be investigated.
    Chairman BAKER. You gentleman have raised a panoply of issues which are going to take us some while to unwind, if it is possible. Since we are talking about something we cannot define that nobody seems to regulate, that nobody can explain how they performed so well, for which so many dollars are invested, we have got a lot of homework ahead of us.
    Let me express my appreciation for your longstanding patience in the hearing today. The bells have just gone off for votes on the floor, but the committee would reserve the right to forward additional questions, particularly in light of Mr. Kanjorski's line of questioning on specifics of allegations relating to activities that each of you might have raised from different perspectives. We look forward to working with you in the months ahead toward resolution of this important matter.
Thank you very much.
    [Whereupon, at 1:02 p.m., the subcommittee was adjourned.]