New World Order of Hedge Fund Regulation?
As Bernie Madoff settles into his new permanent home at the Butner Federal Correctional Complex, about 30 miles north of Raleigh, NC, the hedge fund management industry, as well as the larger investment management sector, is itself settling into what portends to be a new world order of increased regulation and governmental scrutiny. Numerous proposals for registration at the federal and state level as well as calls for stepped-up enforcement of existing regulatory obligations signal what will likely be a new era of regulation for hedge fund managers. Below, we profile some of the more visible developments at both the federal and state levels.
At the Federal Level
Since the beginning of 2009, there have been a number of legislative proposals emanating from both houses of Congress as well as from the Obama administration, all of which seeking to bring the hedge fund industry under increased regulation, through the registration of either hedge fund advisors or the actual funds themselves. As of this date, while no one proposal has moved significantly beyond the introduction phase of the legislative process, sentiment remains strong on the part of many legislators for the need to enact some level of added regulation on the industry.
The latest season of hedge fund re-regulation proposals began on January 29, 2009, with the introduction by Senators Charles Grassley (R-Iowa) and Carl Levin (D-Michigan) of proposed legislation entitled the Hedge Fund Transparency Act of 2009 (the HFTA), which, if enacted, would have a profound impact on the entire private fund industry comprising hedge funds and private equity funds (private funds). The HFTA, unlike other later proposals, seeks to achieve the goal of increased regulation by means of replacing current exceptions to the Investment Company Act of 1940 (the Company Act) commonly invoked by private funds with new watered-down exemptions that, while not subjecting private funds to the full array of Company Act regulations applicable to mutual funds, nonetheless establishes the authority of the Securities and Exchange Commission (the SEC) to oversee and regulate these private funds. Specifically, the HFTA would require private funds of at least $50 million in assets under management (AUM) relying on the new lite version exemptions to, among other things, register with the SEC, maintain books and records as required by the SEC, and file an annual information form that discloses, among other things, the identities of fund investors and the value of fund assets. The bill also proposes requiring these funds to establish anti-money laundering (AML) programs and to report suspicious transactions.
The novelty of the HFTA is that instead of amending the Investment Advisors Act of 1940 (the Advisors Act) to require fund managers to register as investment advisors under the Advisors Act, the HFTA amends the Company Act to require the funds themselves to register as investment companies (albeit to a lesser degree than required of mutual funds).
As noted, the HFTA would add require private funds with AUM of $50 million or more that wish to rely on the new exemptions to comply with the following conditions:
Registering with the SEC.
Filing an annual information form with the SEC.
Maintaining the books and records required by the SEC.
Cooperating with any requests for information or examination by the SEC.
The aforementioned information form would be filed electronically on an annual basis. It would be made publicly available in an electronic, searchable format, and must include all of the following:
The names and current addresses of: (i) all natural persons that are beneficial owners of the fund; (ii) companies with an ownership interest in the fund; and (iii) the fund’s primary accountants and brokers.
An explanation of the structure of ownership interests in the fund.
Information on any affiliation that the fund has with other financial institutions.
A statement of any minimum investment commitment required of a limited partner, member, or other investor in the fund.
The total number of any limited partners, members, or other investors in the fund.
The current value of: (i) the assets of the fund; and (ii) any assets under management by the fund.
Later on in the year, the Obama administration weighed-in with its own proposal, known as the Private Fund Investment Advisors Registration Act of 2009 (the Obama Proposal), as part of its larger effort to implement macro-level financial industry regulatory reforms. The Obama Proposal, released by the U.S. Treasury Department on July 15, 2009, seeks to require all advisers to private funds with more than $30 million of AUM to register with the SEC under the Advisors Act. The Obama Proposal achieves this end by requiring any investment advisor with greater than $30 million in AUM to register with the SEC, regardless of the number of clients the advisor has. In essence, the Obama Proposal would effectively eliminate the small advisor exception available to advisors with fewer than 15 clients currently provided by Section 203(b)(3) of the Advisors Act.
The Obama Proposal broadly defines a private fund to include any 3(c)(1) or 3(c)(7) investment fund that meets one of the following requirements: (i) it is organized in or created under the laws of the United States or a State, or (ii) it has 10% or more of its outstanding securities owned by U.S. persons. This, in turn, would effectively require the advisor to any hedge fund, venture capital fund, or private equity fund organized in the U.S. or with 10% or more of its outstanding securities owned by U.S. persons to register with the SEC.
The Obama Proposal would authorize the SEC to require any registered investment advisor to file reports regarding the funds that it advises, which would include the following:
The amount of AUM;
The use of leverage (including off-balance sheet leverage);
Counterparty credit risk exposure;
Trading and investment positions;
Trading practices; and
Any other information that the SEC determines is necessary or appropriate in the public interest and for the protection of investors or for the assessment of systematic risk.
Pursuant to the Obama Proposal, all of this information will be kept confidential; except, that the information may be shared with Board of Governors of the Federal Reserve System or any other entity that the SEC determines to have systematic risk responsibility.
Also on July 15, 2009, Andrew Donohue, Director of the Division of Investment Management of the SEC, testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs about the need for increased regulation and oversight of private funds. In his testimony, Mr. Donohue stated that the SEC supports the registration of private fund advisors under the Advisors Act. On numerous occasions, Mr. Donohue explicitly supported the Private Fund Transparency Act of 2009 (the PFTA), a proposal introduced by Senator Jack Reed (D-Rhode Island) which largely parallels the Obama Proposal. According to Donohue, the PFTA would provide the Commission with needed tools to provide oversight of this important industry in order to protect investors and the securities markets.
On the House of Representatives side of the aisle, the Hedge Fund Advisor Registration Act (HFARA) has been filed and referred to the House Committee on Financial Services. The HFARA, sponsored by Representatives Michael Capuano (D-Massachusetts) and Michael Castle (R-Delaware), would, akin to the PFTA and Obama Proposal, amend Section 203(b)(3) of the Advisors Act to remove the exemption from registration provided to investment advisors with fewer than 15 clients.
Most recently, on October 1, 2009, Representative Paul Kanjorski (D-Pennsylvania), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, released discussion drafts of the House version of the PFTA and Obama Proposal, which is also called the Private Fund Investment Advisors Registration Act of 2009.
At the State Level
As a knee-jerk reaction to the Madoff fiasco, state regulatory agencies are also increasingly taking aggressive positions with respect to hedge fund advisors. State regulators are interpreting their advisory rules and regulations much more conservatively, both at the initial registration stage and then later during audits/inspections of registered advisors. Such scrutiny is, in our opinion, significantly extending the initial registration process for the typical investment advisory firm that directly manages, or is somehow involved with, any pooled investment vehicle, such as a hedge fund or private equity fund.
For example, the state of Washington has been a leader in the movement towards tighter regulation of hedge funds through the enforcement of its Notice to Hedge Fund Managers Regarding the Use of Partnership and LLC Agreements to Satisfy the Written Investment Advisory Contract Requirement (issued September 26, 2006) (the Notice). In the Notice, the Washington Department of Financial Institutions Securities Division (DFI) stakes out a very activist stance with respect to hedge fund managers registered or required to be registered with DFI. Pursuant to applicable state advisory law, investment advisory contracts are required to be in writing and contain certain provisions. Accordingly, to the extent that a hedge fund manager that is registered with DFI as an investment advisor relies on a funds organizational document, such as a limited partnership (LP) or limited liability company (LLC) agreement, to satisfy this written advisory contract requirement, DFI demands that such organizational document contain all provisions mandated by the DFI. The implication of this is that DFI will claim review and edit rights with respect to all of a DFI-registered advisors offering documents. Unfortunately, this can dramatically extend the time involved in both receiving DFI’s approval of an application for investment advisory registration as well as the finalizing of a funds offering documents. While creating a separate investment management agreement distinct from the funds offering documents might seem a viable means of avoiding this inquiry, it is likely that DFI will demand the same review and edit rights notwithstanding. Like Washington, many other states now are also closely reviewing fund offering documents, and demanding numerous rewrites. Unfortunately however, pushing back on these issues, no matter how justifiable from an advisor’s perspective, can in turn be problematic as the state holds the ultimate trump card here, withholding registration.
Another area in which many of the states are taking an aggressive stance is with respect to counting clients for the purposes of registering in a state. Despite the resounding defeat of the SEC’s hedge fund rule in federal court as a result of the Goldstein v. SEC decision involving Philip Goldstein of Bulldog Advisers, many states are adamantly maintaining that the cornerstone of the hedge fund rule, its look-through provisions, apply to advisors seeking to register in those states. That is, these states believe that investors in a hedge fund (be they limited partners, members, or shareholders) are all clients of the hedge fund advisor. Thus, under this interpretation, a hedge fund formed as a limited partnership with, for example, 16 limited partners in State A, would need to count all 16 persons as clients in State A. Utah, Nevada, and Washington are but a few of the states currently taking this position.
Interestingly however, our research has shown that very few (if any) states securities acts and associated securities regulations actually contain such provisions. Thus, it is quite likely that the majority of states maintaining this aggressive stance with respect to counting clients are doing so unconstitutionally. This is so because all of the states have their own constitutions just like the federal government. Under these constitutions, a state legislature makes laws, the state’s executive branch agencies (which are under the governor) implement and enforce these laws, and the state judiciary interprets them. State agency rules must be authorized by existing statutes and must be promulgated pursuant to the Administrative Procedures Acts of the states (which all require notice and comment, in other words, due process). Accordingly, agencies cannot just make up policies that have no basis in law and/or have no basis in rules that have been subject to public comment. To the extent that a state defines an adviser’s client to include fund investors without there being any statute or rule establishing such a definition, this appears to be what many states are in fact doing though. Unfortunately, the small hedge fund advisor without substantial legal resources may not be in a position to argue with a regulator on this matter. Indeed, very few advisors are likely to take the route that Philip Goldstein of Bulldog Advisers took, i.e., suing and beating the SEC in court!