It was probably just a matter of time before Senator Chuck Grassley collided with the hedge fund industry. The 73-year-old Republican, who grew up on a farm in New Hartford, Iowa, and exudes a 4-H Club earnestness, has spent much of his 33 years in Congress pursuing openness, accountability and transparency. You might remember him as the politician who asked the Defense Department to explain how the Air Force could pay $7,600 for a single coffee pot and the Pentagon $1,868 for a toilet seat cover. He pushed for laws to allow television cameras into federal courthouses. He recently received a lifetime achievement award from a group of public advocacy organizations for his defense of whistle-blowers.
By inclination and by law, hedge funds are famously nontransparent, and that bothers Grassley so much that in May he introduced the Hedge Fund Registration Act of 2007. Though only two pages long, it’s a milestone piece of legislation that, if passed, would require advisers of all but the smallest hedge funds to register with the Securities and Exchange Commission. In effect, it would turn back the clock to early 2006, when, for a brief five months, the SEC had an almost identical rule that was tossed out by a federal appeals court.
“The SEC ought to have this authority,” Grassley tells Alpha in an exclusive interview (see page 41).
Had anyone but Grassley, ranking minority member of the Senate Finance Committee, sponsored the Hedge Fund Registration Act, the legislation probably wouldn’t merit a second look. His willingness to work with Democrats to advance his ideals bodes ill for the hedge fund industry. Just this month, Grassley and the Senate Finance Committee’s new chairman, Montana Democrat Max Baucus, introduced a bipartisan bill that, if passed into law, could derail plans by private equity firms like New Yorkbased Blackstone Group to go public -- or at least make it a lot less attractive -- by closing a loophole that allows listed traded partnerships to pay lower taxes than corporations. As Grassley tells Alpha, he is similarly concerned about the tax rate being paid by hedge fund managers.
Grassley’s interest in registering hedge funds, however, is at odds with much of the current thinking in Washington. As John Gaine, president of the Managed Funds Association, a Washington-based organization that lobbies on behalf of hedge funds, points out, most U.S. regulators have moved on to more sophisticated ways of reining in hedge funds. From the Federal Reserve Bank of New York to the SEC itself, the emphasis has shifted from registration to helping a self-regulated industry deal with systemic issues, risk management and information sharing.
“No one is endorsing registration,” Gaine says. “As an issue, it’s not in play.”
In the U.S. the calls for greater hedge fund regulation began dying down last summer, when the SEC decided not to challenge the appellate decision overturning registration. SEC chairman Christopher Cox, who was not a member of the commission at the time the rule was approved, passed up the chance to ask for registration legislation from Congress when he testified before the Senate Banking Committee in July 2006 but said that as a general principle future SEC regulations and legislation should be as “nonintrusive” as possible. In February the President’s Working Group on Financial Markets -- which includes the chairmen of the SEC, the Federal Reserve Board and the Commodity Futures Trading Commission, as well as the Treasury secretary -- also concluded that a light regulatory touch was sufficient for hedge funds. Grassley’s Hedge Fund Registration Act of 2007, it seems, is the present nobody wants.
Not that it makes the slightest difference to the senator. He sees himself as a watchdog looking out for the average American, and he is not shy about taking on the powerful and wealthy -- or even his own party -- in that role. In 1991, Grassley was one of just two Republicans to vote against the resolution authorizing the first Gulf War. More recently, he has come out against the immigration bill backed by the administration of George W. Bush, saying it would threaten taxpayer privacy by giving the Department of Homeland Security unlimited access to confidential tax return information.
Grassley, whose independent-minded approach is mixed with prairie populism, says he first encountered the opaque world of hedge funds in 2005, when he began working on legislation to protect pensions and help middle-class Americans save more for retirement. From his perspective, all the work he had done to make pension funds more transparent was being undermined by their investments in unregistered shares of hedge funds. During the past 12 months, Grassley has been one of the hedge fund industry’s severest critics, decrying its secrecy, influence on regulators and possible criminal activity.
“He is worried about the social and political implications of hedge funds,” says Jonathan Spalter, chairman and CEO of Public Insight, a New Yorkbased firm that provides research on regulatory issues. “As a bellwether for what might be an emerging perspective, Grassley should really be listened to carefully by the industry.”
Grassley’s collision with the sector began last summer, when a series of events involving hedge funds grabbed the Iowa senator’s attention. First, a former SEC investigator named Gary Aguirre presented information to Grassley, then chairman of the Senate Finance Committee, and to Republican Senator Arlen Specter of Pennsylvania, who headed the Senate Judiciary Committee. Aguirre claimed he had been fired for investigating alleged insider trading by Pequot Capital Management, a multibillion-dollar hedge fund firm based in Westport, Connecticut. He more than hinted that it was because powerful outsiders had put pressure on the SEC when Aguirre was preparing to depose Morgan Stanley CEO John Mack, who briefly worked at Pequot and is a close friend of its founder, Arthur Samberg. It was just the sort of event to activate Grassley’s defenses on behalf of a whistle-blower.
Grassley joined with Specter in calling the hedge fund industry to account. After Senate hearings on Aguirre’s accusations, Grassley and Specter ordered a joint investigation by the Finance and Judiciary committees of the SEC’s own investigation of the insider trading allegations. Their interim report, released in February, criticized the SEC and questioned its “ability to protect all investors, large and small, with an even hand.” A full report is due out shortly.
And at Grassley’s request the Government Accountability Office, the investigative arm of Congress, conducted a broad review of the SEC’s enforcement and compliance divisions in the wake of the agency’s insider trading investigation. The GAO’s report is due in July.
Arguably, for Grassley, protecting pension accounts ranks in importance just below shielding whistle-blowers, and when the $9 billion Amaranth Advisors hedge fund collapsed in September, it was another black mark against the hedge fund industry that he couldn’t ignore. Amaranth’s stunning $6 billionplus loss in just two weeks, caused by wrong bets on the energy market, dragged pensioners down with it. The San Diego County Employees Retirement Association had invested $175 million with Amaranth and claims in a lawsuit that it lost an estimated $105 million when the hedge fund folded.
Grassley expressed shock that his staff members were unable to find the names or telephone numbers of hedge funds anywhere, and he fired off a fact-finding letter to the U.S. Treasury, the Department of Labor and the SEC, among others, asking them to report back to him as to whether hedge funds were required to file information with them.
A third event involved another of Grassley’s signature crusades -- transparency. In June 2006 the U.S. Court of Appeals for the District of Columbia Circuit ruled that the SEC had overstepped its authority in requiring hedge fund advisers to register. Grassley’s concern grew when the SEC decided not to contest the ruling.
The hedge fund industry was on the wrong side of Grassley’s three passions: whistle-blowing, pension protection and transparency. And recent disclosures that some offshore U.S. hedge fund managers are treating their income as long-term capital gains instead of as earned income and paying a 15 percent tax rate instead of a 35 percent rate won’t help their case. Nor, presumably, do reports that the world’s 25 top-paid hedge fund managers took home an average of $570 million last year.
In March, Grassley tried to include hedge fund registration as part of the “America’s Security Act” -- the so-called 9/11 Commission Recommendations bill -- but withdrew it because, as he later said in a Senate floor statement when he reintroduced the bill, “it didn’t have many friends” among his congressional colleagues.
“These funds don’t want people to know what they do, and they have fought hard to keep it that way,” Grassley said when he withdrew his amendment.
Grassley introduced the Hedge Fund Registration Act in mid-May without any co-sponsors. The bill amends the Investment Advisers Act of 1940, and if enacted, would require all but the smallest hedge funds -- those with less than $50 million in assets and fewer than 15 investors -- to register with the SEC. The odds of the law even getting out of committee are low because Grassley is not a member of the Senate Committee on Banking, to which the bill has been referred. Nor has registration been a big topic at the House Financial Services Committee, where Democratic Representative Barney Frank of Massachusetts has been holding a series of hearings on hedge funds and private equity. Even if the Senate Banking Committee holds hearings on hedge funds later this year, as is rumored, registration isn’t expected to be a main topic.
But that presumes that none of today’s 9,000 or so hedge funds, which collectively manage $1.6 trillion in assets, runs into any serious trouble. If another big hedge fund were to implode along the lines of Amaranth, attention could quickly turn to Grassley’s bill amid renewed cries for transparency and accountability. The senator recently spoke with Alpha Contributing Writer Jaye Scholl about hedge funds and why he thinks registration matters.
Alpha: Are hedge funds, as some say, one of the miracles of the modern capitalist system or are they more of a headache?
Grassley: The hedge fund industry is a miracle, and it’s doing a lot of good. I don’t have any problems with the industry. I only want to make sure that middle-income pensioners and pensions are protected. It seems to me you need a great deal of transparency. And so all I’ve done to this point is not question the legitimacy of hedge funds. I’ve just questioned whether we know what we need to about them to make sure investors are protected.
Why is hedge fund registration so important?
The SEC thought it had the authority, but the courts said it didn’t. So I want it to be an allowable issue with the SEC, and the only way you can do it is to overturn the D.C. Court of Appeals case.
Was there a particular reason you introduced the Hedge Fund Registration Act now?
No.
Your bill doesn’t have any co-sponsors. Are you trying to get them?
We’re trying to get a lot of them, and we’re going to send out a “Dear Colleague” letter to do so. That’s kind of standard procedure.
Your bill has been referred to the Senate Banking Committee, which is chaired by Democratic Senator Christopher Dodd of Connecticut, a state that is home to many hedge funds. How likely is he to move on this bill?
Well, I haven’t talked to him, so I don’t know. But I know Senator Dodd to be a fair person who believes you’ve got to have confidence in the marketplace. And I think he is a person who looks out for middle-income people as well.
I know from my work with pension legislation, as a member of the Senate Finance Committee, that middle-income people can lose their pensions. My main motivation is to make sure we protect middle-income pensioners and pensions.
You and Pennsylvania Senator Arlen Specter have been two of the strongest voices calling for reform of hedge funds. It seems ironic that two Republicans are pressing for more regulation, not less.
Well, you ought to look at it this way. I think you would find both Senator Specter and me following a very clear Republican principle: We want to encourage the marketplace to work. But for the marketplace to work, government has a responsibility to make sure there’s transparency and everything is aboveboard.
Why haven’t the Democrats been more aggressive?
I think you ought to look at the contributions of hedge fund people. Last fall my staff concluded that for about every dollar going to Republicans from hedge funds, $3 went to Democrats.
Can there be any reform of the hedge fund industry while Congress is controlled by the Democrats?
Maybe there can’t be. But I don’t accept the proposition that I am looking to reform the industry. The only thing I’ve done is introduce legislation to overturn an appeals court decision that said the SEC couldn’t require registration. That can’t be considered wanting to reform the system.
It seems a lonely crusade. SEC chairman Christopher Cox has said that he isn’t going to revisit registration. Nor have there been a lot of people in Congress working on the registration issue, save you.
Well, that may be. Chairman Cox may not ask for registration, even if my bill does pass. But right now he couldn’t require registration even if he wanted to. I think this is the least we can do -- have registration for transparency because hedge funds affect regular people now, not just the superrich.
You said that when you first offered your amendment in March, your office received lots of calls from powerful people who don’t want to see registration. Who called?
Well, I won’t give names, but it was hedge funds or people close to them or lobbyists they hire here in Washington. And I want to make it clear: It wasn’t just my phones that were ringing off the wall -- probably less my phones than the phones of a lot of other members. One senator came up to me and said, “You’re going to make it difficult for us Republicans to raise money.” Well, that ought to tell you something.
Critics argue that registration will drive the hedge fund business offshore. What do you say to them?
All I can do is ask a question in return. When has transparency ever driven business out of the U.S.? Other things have driven business out of the U.S. but not transparency.
Could registration have prevented the collapse of Amaranth?
It’s very difficult to make that judgment. But I know this: The SEC, unless it starts having this registration, isn’t going to be able to track what managers are doing. This law gives them an opening to do it, and it brings confidence to the market.
Hedge funds argue that transparency will make it easier for competitors to steal their ideas.
Why do you think we got the SEC in the first place? If you go back to the 1920s, people were using the same argument.
I just think that the SEC should have all the tools available. I’m not saying the SEC has to use them, but I don’t think it ought to be stymied by a court case.
Do you intend to pursue other aspects of the hedge fund industry in the year ahead?
Yes, but it’s not just my effort. It’s also an effort on the part of the people on the Senate Finance Committee. We’re looking at the issue of hedge fund managers’ income. Is it capital gains or earned income?
Where is the rest of Congress on this?
I think the rest of Congress is going to be involved if it comes to offsets for the tax policy and the expenditure policy of the Democratic majority. Where are they going to get all that money? And I don’t know whether our investigations will show a lot of it can come from the hedge funds -- the taxing of money that is considered investment income as opposed to earned income. We’re still investigating.
Could you ever imagine investing in a hedge fund?
Well, I probably am invested in hedge funds through some mutual funds or some pension funds. I don’t invest in individual stocks and so I don’t invest in hedge funds. But there could be managers of my money that do. I have no way of knowing that. I suppose I could ask them, but I don’t know, and I don’t care to know.
Hedge Funds’ European Summer Vacation
As hedge fund managers in the U.S. monitor Iowa Senator Chuck Grassley’s growing interest in their business, they can rest a little easier about the movement toward greater hedge fund regulation on the other side of the Atlantic. At the heart of the recent European activity has been German Chancellor Angela Merkel, who is using Germany’s yearlong presidency of the Group of Eight leading industrialized nations to push for greater control of hedge funds. A physicist by training, Merkel expressed her concern about hedge funds in January at the World Economic Forum in Davos, Switzerland.
“We want to minimize the systemic risks in international capital markets and to raise their transparency,” the German chancellor said. “Above all, I see the need to catch up with hedge funds.”
Capitalizing on the groundswell of support for greater monitoring of hedge funds that was building early this year, Merkel secured an agreement from the Group of Seven finance ministers to scrutinize the European industry more closely. Announcing that the issue would be at the top of her agenda for the G-8 presidency, she restated proposals for greater transparency developed by German Finance Minister Peer Steinbrück. These included direct talks with industry bodies about future regulatory options, including lending limits on prime brokers, compulsory registration and changes to minimum investment rules.
Merkel’s pro-regulatory stance is rooted in the broad condemnation in Germany of the move in 2005 by a pair of activist hedge funds -- the Children’s Investment Fund Management U.K. and New York’s Atticus Capital -- to block Deutsche Börse’s bid for the London Stock Exchange. This successful play resulted in the resignation of Deutsche Börse chief executive Werner Seifert and widespread denunciation of activist investing across the German political spectrum, with Franz Münterfering, then chairman of the ruling Social Democrats, describing such investors as “locusts.”
The chancellor’s push for greater regulation has attracted support throughout Europe. Nicolas Sarkozy, the recently elected president of France, has said he will push for a Europe-wide tax on speculative bets by hedge funds, while Jean-Claude Trichet, president of the European Central Bank, has repeatedly advocated a central registry of prime brokers’ exposures to hedge funds.
In what was widely seen as a concession to Merkel’s demands, a meeting of G-7 finance ministers in February commissioned the Basel-based Financial Stability Forum to reassess the systemic risks posed by hedge funds in a follow-up to its 2000 report on the subject. (The FSF, which brings together central bankers, regulators and treasury officials, was created in 1999 after the near-collapse of Long-Term Capital Management to monitor the effects of hedge funds on global market stability.) Meanwhile, the question of monitoring prime brokers’ exposure was gaining traction in the U.S. In December the Securities and Exchange Commission met with the U.K.'s Financial Services Authority and leading prime brokers in New York to discuss margin practices.
Still, important obstacles to change remained in the run-up to the G-8 summit at the German seaside resort of Heiligendamm in early June. The U.S. consistently rebutted calls for regulation, with Treasury Secretary Henry Paulson Jr. opposed to moves to increase disclosure, arguing that they could harm innovation and reduce liquidity in the industry. Similarly, FSA chairman Callum McCarthy opposed a central registry of hedge fund exposure on grounds that it would be impractical, useless and “a considerable moral hazard.”
As winter waned, so too did support for Merkel’s hedge fund agenda. German officials were admitting that the objective for the G-8 summit was not tangible regulation but merely a start to the discussion on hedge fund transparency. During February and March, Merkel’s statements dropped any mention of the twin pillars of the German position -- a central registry of positions and capital regulation of hedge funds (setting limits on leverage). By the beginning of May, when the European Union’s Economic and Financial Affairs Council published its report on hedge fund transparency, German Finance Minister Steinbrück had moved from calling for external regulation with enforced transparency to a request for self-regulation -- the so-called voluntary code of conduct.
At the end of May, the summit of G-8 finance ministers in Potsdam, Germany, endorsed the report from the FSF. Drafted expressly for the summit, the report stopped well short of requesting a voluntary code of conduct, focusing instead on the review and enhancement of existing industry sound-practice benchmarks and the possibility of greater disclosure of prime brokers’ exposure to hedge funds.
Further calls for a voluntary code, restated by Steinbrück at Potsdam, attracted broad criticism. U.S. deputy Treasury secretary Robert Kimmitt insisted that any such code should be developed by the industry, not government bodies, while U.K. Chancellor of the Exchequer Gordon Brown pointed out that there was nothing in the Potsdam statement to endorse a voluntary code. The hedge fund industry was similarly curt, with Florence Lombard, executive director of London’s Alternative Investment Management Association, rejecting a broad international voluntary code. Even Merkel conceded to the German newsweekly Der Spiegel on the eve of the G-8 conference in Heiligendamm that the initiative to secure tangible commitment on greater regulation at Potsdam had failed.
So with U.K. and U.S. Treasury officials holding firm, the absence of an interpreter during Merkel’s private discussions with George Bush at the June G-8 meeting is unlikely to have confused any message coming from the U.S. president on hedge fund regulation. Indeed, as far as this issue was concerned, the meeting provided a rubber stamp to a consensus arrived at several weeks earlier.
Which is not to say that the Germans have abandoned the possibility of greater hedge fund regulation. Merkel’s G-8 presidency extends through the end of December; both she and Steinbrück have emphasized that making progress on the issue will take the duration of the presidency. But with half the term now elapsed, an agreement looks no closer. -- Hugo Cox
