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At the end of October, the House Financial Services Committee moved forward on two of the topics previously tracked by this blog, and introduced a third into the discussion.

On the 27th, the Committee approved H.R. 3818, the Private Fund Investment Advisers Registration Act, which requires advisors to private pools of capital to register with the SEC, and subjects them to new recordkeeping and disclosure requirements.   The bill, a derivative of the proposed legislation submitted by the administration in July and discussed in a posting at that time, was introduced by Representative Paul Kanjorski on October 15. The markup draft does incorporate several material changes from the earlier proposal.



Barney-Frank-EtcThe next day the Committee approved H.R. 3890, the Accountability and Transparency in Rating Agencies Act.   This bill was also introduced by representative Kanjorski based on the administration’s proposed Improvements to Regulation the of Credit Rating Agencies that was discussed in this earlier post.

Both of these bills received strong bipartisan support in the Committee. Going forward, their progress can be tracked on the widgets to the left.

On the 27th, the Committee also began considering the Financial Stability Improvement Act, their version of an administration proposal to require financial firms, including hedge funds, with more than $10 billion in assets to cover the cost if the government takes over financial institutions whose failure could pose a systemic risk.   This bill is a compromise worked out between the Treasury Department and Committee Chairman Barney Frank.

All three of these developments and their potential impacts on the hedge fund industry will be discussed in greater detail in upcoming posts in our InDepth Section.

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Evolutionary theory includes a vacant-niche hypothesis that new species sometimes arise when evolution fills a niche that had sufficient available resources but was not already been occupied by another organism.  Darwin’s observation of the evolution of finches to fill different available niches distributed among the Galapagos Islands was an example, as was the evolution of a number of Australian marsupials to resemble species that evolved elsewhere to fill comparable vacant-niches.

Similarly, the gap created by the combination of exemptions from registration under the 33 Act, the 34 Act, the Advisers Act, the Commodity Exchange Act (CEA), and the 40 Act created a opportunity rich vacant-niche that played a key role in the development of hedge funds. This article will analyze the substance of those exemptions, the application of each to hedge funds, and the ways in which they have determined some of the more distinctive structures and practices adopted as standard practice by the industry.  Other articles (or, more likely, a series of articles) will analyze the changes in such standard practices, as legislation limits or removes one or more of the exemptions.  To date, there are proposals by Congress and the Administration to close or limit the Advisers Act and 40 Act exemptions.

Without exemptions, a hedge fund and its adviser would be required to register under four or five statutes, depending on whether it invested in commodities.  Hedge funds are usually limited partnerships; ownership interests in LPs are classified as securities under the 33 Act, and so that Act would require registering the funds’ shares with the SEC before any sales or offers to sell, and the 34 Act would impose a registration requirement while the shares were outstanding.

As companies primarily engaged in the business of investing the pooled assets of investors in securities, hedge funds are investment companies as defined in the 40 Act and as such would be required to register under that Act, and as Commodity Pool Operators (CPOs) under the CEA if they trade instruments regulated by the CFTC. And finally, the management company directing investment of the funds is a business compensated for advising others concerning investments in securities, making it an investment adviser under the Advisers Act, and potentially a commodity trading adviser (CTA) under the CEA, each of which would require registration under the respective Act.

A simplified view of the general structure typically used to issue and manage hedge funds, and the corresponding exemptions from SEC registrations, is shown in the diagram below and in greater detail in the table at the end of this article.

Hedge Fund Entity Structure Overview

Each of the five statutes, however, includes one or more exemptions from registration that were originally designed to limit their impact on firms presenting limited risk either because they were too small, or because they served clients who needed less protection. Each exemption was adopted independently, at different times and in statutes designed to address different issues.  The hedge fund industry has used them in combination to create a business niche that has enabled them to invest differently, and arguably more successfully, than registered firms while restricting the ability of registered firms to compete – in short, they’ve used them to create a fertile vacant-niche.

The relevant exemptions under the five Acts, and their application to hedge funds, are analyzed below.

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The future direction of SEC enforcement was described in broad terms by Robert Khuzami, the new Director of the SEC’s Division of Enforcement, in a speech to the New York City Bar earlier this month.  Khuzami characterized his short tenure at the commission as a time of rapid change, driven in large part by the repercussions and criticisms resulting from the Madoff scandal.  The speech laid out new guiding principles for the Division, including a focus on strategic cases involving major breaches or the potential to deter violations, swift SEC action after a violation, allocation of Division resources to maximize their impact, and increased litigation success based on building stronger cases.

Khuzami announced several specific initiatives related to those principles.

Structural Changes

The proposed changes are responsive to the criticisms raised in the GAO Report on the Enforcement Division, which was delivered this past March and reviewed in a Senate hearing in May.  During the hearing, Richard Hillman, the responsible GAO manager, discussed a number of shortfalls in the Division and a series of recommended changes, which were agreed to by Director Khuzami (who also testified) and are now closely paralleled in the changes he is adopting for the Division.  In particular, the Division will create five specialized units, each having the expertise to enforce a particularly complex area of securities law, with the goal of becoming more efficient and effective in selecting the tips to be investigated and in following up quickly where violations are suspected.  Of particular interest to the hedge fund community, an Asset Management Unit will focus on hedge funds, investment advisors, investment companies, and private equity funds.  Disclosure, valuation, portfolio performance, due diligence and diversification, transactions with affiliates, misappropriation, and conflicts of interest were identified as expected areas of concern.

An Office of Market Intelligence will be created to support the specialized units by collecting, analyzing, risk-weighting, triaging, referring and monitoring progress on tips, complaints and referrals.  The unit will apply internally-developed risk criteria and priorities, possibly reflecting a movement toward a risk-based examination model, as was championed by SEC Chairman Mary Schapiro when she led the NASD/FINRA.

Branch chiefs will be redeployed to conduct investigations in order to increase investigative resources and eliminate duplicative efforts, unnecessary internal reviews and delays in decision-making.

Given the resources being added to investigations and the increase in the Division’s willingness to go to trial, plans call for adding staff to the Trial Unit.  The Division also plans to hire a Chief Operating Officer to manage IT, internal projects, and workflow improvements, along with added support and technical personnel to free up the front-line lawyers who are now responsible and provide them with additional tools for doing their jobs.

Realigned Decision-Making

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Earlier this week, the FSA provided a solid example of rules that address risks created by poorly structured remuneration programs. The FSA rules demonstrate an alternative to pending US legislation and highlight the importance of acting quickly to control 2010 compensation. Under the rules, firms are required to adopt remuneration policies reflecting an included list of principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st. The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

The FSA focused on risks from badly structured compensation agreements, specifically not attempting to address perceived compensation excesses (which are in any case less prevalent than in the US):

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

The code specifies that compensation programs should be based on risk-adjusted long-term profits not revenues, reflect adherence to risk and compliance policies, individual, division, business unit, and firm performance, and Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year. It also calls for limiting guaranteed bonuses to the first year of employment, and spreading payment of at least two-thirds of any senior employee bonuses over a three-year period.

Firms with inconsistent contract obligations are called upon to amend such obligations within set time frames.

Our detailed analysis of the FSA rules and a comparison with USA proposals are available here.

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Summary: Detailed analysis of new FSA rules designed to prevent UK financial services firms from adopting remuneration programs that could encourage key staff to take excessive risks; includes a comparison to US proposals. A briefer entry is available here.

Earlier this week, the FSA provided a workable example of rules that address the risks that can result from poorly structured remuneration programs at financial firms.  Given the uncertain and politically charged debate now underway in the US, this example deserves our attention.  The new FSA rules also highlight the importance of acting quickly enough to affect the upcoming 2010 compensation year – something that will be difficult here where pending legislation provides regulators with a nine-month period to in effect assess the need for action.

By already putting its requirements into effect, the FSA pulled ahead of its counterparts in the US.  The changes go into practice quickly to address the 2010 compensation cycle: firms must adopt remuneration policy statements reflecting the new principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st.  The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

To act quickly, the FSA focused specifically on the risks created by badly structured compensation agreements, rather than getting caught up in a debate about popular outrage over perceived excesses as has happened in US.  In balancing its reform efforts, the FSA noted that “inappropriate remuneration policies, practices and procedures were a contributory factor rather than a dominant factor behind the market crisis.”  As such, the UK code provides an interesting example of regulations more in tune with traditional financial regulation – mandating formal policies and procedures, internal oversight roles, and specific practices – than the US approach, summarized in another posting on this site, which attempts to limit risk by ceding more compensation authority to shareholders and regulators.

In its newsletter, the FSA describes the intent of the code as getting boards and firms to adopt compensation incentives that more strongly promote good risk management practices:

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

In keeping with the results focus at the heart of policy-based regulation, the provision anticipates efforts to engineer around any rules-based limits, extending coverage to “all aspects of remuneration that could have a bearing on effective risk management including wages, bonus, long term-incentive plans, options, hiring bonuses, severance packages and pension arrangements.”

Content of the FSA Rules

Structurally, the code modifies existing provisions to require firms to have board-level compensation committees and adopt written compensation policies and procedures.  The procedures must include performance appraisal processes and must allow for the risk and compliance areas to have “significant input” if they are concerned that a decision could encourage risky behavior or include a potential conflict of interest.  The code also extends the definition of regulated business risk to include risks arising from remuneration policies.

The code amends the Senior Management Arrangements, Systems and Controls Sourcebook to include a series of new principles to be applied when setting remuneration for individuals who could significantly impact the performance or risk exposure of the firm.  Under these principles, their compensation should:

  • Be based on risk-adjusted profits not revenues
  • Reflect long term profits, potentially through the use of moving averages, deferred payouts, or risk adjustments
  • Be significantly affected by an individual’s non-financial performance, including adherence with the firm’s risk and compliance policies
  • Tie bonus levels to individual, division, business unit, and firm performance (their emphasis)
  • Include vesting periods and dependencies on future firm performance for deferred bonuses
  • Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year
  • Be set using appropriate, accurate management reports for the relevant areas of the business

Beyond these principles, the code calls for two specific compensation practices: first, guaranteed bonuses should be limited to the first year of employment, and second, payment of at least two-thirds of any senior employee bonuses should be spread over a three-year period.  Special considerations also apply to determining compensation of risk and compliance staff whose compensation is expected to be adequate to attract the required talent but “significantly” less variable or performance based than other positions.

Firms unable to comply with the new provisions because of existing obligations will not be considered in violation provided they amend such obligations to be compliant at the earliest opportunity prior to the end of March 2010.  Firms unable to do so by that date must take reasonable steps to amend or terminate the obligations at the earliest opportunity (and in no case later than the end of December 2010) and must adopt specific, effective procedures to manage any risks raised by such obligations while they remain in effect.

Comparison with Proposed US Regulations

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This week both the SEC and the FSA disclosed steps that could lead to restricting certain practices related to high-frequency trading. According to Bloomberg News, the FSA is meeting with market participants including hedge funds, banks, investment banks, and investment managers to assess the overall impact of high-speed trading in the UK.  Yesterday, Senator Schumer announced that Mary Schapiro at the SEC had promised to attempt to enact a U.S. ban on flash orders, one type of high-speed trading in which major firms have a fraction of a second to react while orders are passing through “dark pools” prior to being routed to open public markets.  That promise builds upon a speech in June, in which she pointed to a potential “danger that significant private markets may develop that exclude public investors” when announcing that the Commission was considering restrictions on high-speed trading.

The timing of the SEC investigation is in part a response to a letter to Chairman Schapiro from Senator Schumer condemning the practice as unfair, a part of which is included below.

Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public, allowing those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity. While pre-routing programs can benefit markets by providing additional liquidity, this kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.

Besides any direct impact of potential regulations, the tenor of the discussion contains a significant message. The statements to date emphasize the priority that will be given to achieving fairness in the markets, including the relative weighting given to individual-level fairness over market efficiency in Senator Schumer’s letter.  A similar view was expressed in an opinion by economist Paul Krugman in Monday’s New York Times, in which he questions how “traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve” the markets.

Although articles, including Paul Krugman’s op-ed piece, have focused on Goldman Sachs, NPR reported that the firm has sent a letter to its clients in which it denies engaging in-flash trading or any other programs where information from client orders is used before trades are completed, and revealed that all forms of high-speed trading together were responsible for only about 1% of 2009 revenues.

As reflected in that letter, it is important to bear in mind there are multiple types of high-speed trading; besides the specific mechanism described above for flash-trading, other programs simply rely on reacting to pricing more quickly to take advantage of market conditions.  To put this into context, the Tabb Group published a study last year entitled “The Value of a Millisecond” (link to the catalog entry, not the $3,000 study) in which they concluded that an electronic brokerage firm would lose 10% of its revenues for each 10 millisecond increase in transaction latency.

We believe that one of the key longer-term lessons in all of this comes from the Goldman quote in the NPR article stating that “the most significant challenge ahead is for the regulatory framework to keep current with the rapid pace of innovation in the marketplace.”  It will be important for regulators to keep this in mind as they craft regulations to deal with the perceived issues arising from today’s technology.

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The Washington Post reported today that on at least two occasions the SEC has been forced to grapple with conflicts between their enforcement role and the role of the U.S. government as a significant investor in (Regions Financial) or influencer of (Bank of America) a large financial services firm.  In both cases, the SEC chose to pursue an enforcement action, but additional conflicts are likely to surface in the future since the government has acquired interests in a number of banks and other financial institutions through the TARP program.   Nevertheless, the Post quotes Robert Khuzami, who directs the SEC’s Enforcement Division, as saying that he expects few actual conflicts to arise.   And, for the larger, systemically-important institutions such conflicts may not alter the balancing act underlying their decision to proceed with enforcement: the article points to an example last year where the regulator felt the need to pause to consider a similar concern concerning potential damage to the system if a settlement pushed one or more of the large institutions involved over the edge.

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The Wall Street Journal reported today, and Reuters confirmed, that Secretary Geither called in the heads of the FRB, the SEC, the CFTC and the FDIC (among others) on Friday to lay down the law in no uncertain terms on their mandated public support for the Obama Administration’s reform plans and to demand they stop the “sniping” that has been going in turf wars among the agencies.

In the video clip above (which will include a brief commercial from the Journal), the WSJ’s reporter Deborah Solomon cites growing unease at senior levels with the slow pace in Congress, the pushback from the industry as well as the divisions among the ranks of regulators as sources of the high level of frustration that led to the reportedly tough, expletive-filled meeting atmosphere.

Despite the strong language in the meeting last Friday, at least some of the regulators remain quite independent as far as expressing their views.   In particular, the heads of the OCC and the OTS, which would be consolidated under the Administration’s current proposal, voiced their disagreement. In his testimony before the Senate Banking Committee on August 4th (shown in the clip at right), John Dugan, the Comptroller of the Currency, voices support for many elements of the Administration’s proposals but disagrees forcefully with some key elements, including proposals to give the FRB authority to override his agency’s standards and enforcement in some circumstances, and to consolidate enforcement of consumer provisions in the proposed CFPA, thereby divorcing consumer and prudential regulation.  John Bowman, acting head of the OTS, disagreed with the premises for consolidating his organization noting that the actual distribution of failures did not support the regulator-shopping accusations on which the proposal was based.

In response to a question from Senator Shelby citing the WSJ article, each regulator specifically stated that they all were giving their own, independent views, as is required by the terms of their charters.

Nevertheless, in an interview with the Wall Street Journal on August 13th, Secretary Geithner remained confident that the Administrations program was on track.  As the Journal summarized the situation:

The administration’s plan has lost some momentum since it was unveiled in June, with lawmakers postponing votes on key portions of the proposal, the industry criticizing much of it and regulators battling over turf. But Mr. Geithner said the effort is “doing fine” and predicted the administration will get most of what it is seeking when Congress returns in September.

One certainly would expect the meetings at Treasury to remain interesting at least until the disposition of the proposed legislation becomes clearer.

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On July 27th, the Investor Advisory Committee conducted its kickoff meeting led by its Chairman, Luis Aguilar (an SEC Commissioner).  The Committee, which was announced by the SEC  in June, is chartered “to provide the Commission with the views of a broad spectrum of investors on their priorities,” which the SEC will consider when assessing potential regulatory reforms.

The kickoff deck from the meeting, a press release, and a video archive link are available on the committee’s website. Among the topics the deck lists as being of interest to the Committee are the following:

  • Fiduciary duties
  • Disclosure
  • Investor-director communications
  • Treatment of credit based instruments (like derivatives)
  • Arbitration
  • Valuation
  • Majority voting
  • Proxy voting
  • Corporate governance

Although the topics actually discussed last week were more relevant to retail investors, the topics listed and Committee makeup indicate that future discussions are likely to be of interest to hedge funds.

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In his opening statement on July 24th before the House Committee on Financial Services, Secretary Geithner discussed the Administration objectives and priorities underlying the Financial Regulatory Agency Restructuring plan.  In the oral statement, a clip of which is shown at left, the Secretary emphasized the need for the two new agencies being proposed in the plan: the Consumer Financial Protection Agency and the Financial Services Oversight Council. The CFPA was designed to better target abuses by imposing uniform standards across all institutions and by having authority over sectors the Administration sees as having been under/unregulated.  The FS Oversight Council is to promote financial stability by addressing risk taking practices, including the use of leverage seen as excessive, that are thought to have contributed to the current crisis by (1) addressing a broader range of institutions, (2) working toward international cooperation and enforcement, and (3) having stability as its primary goal, which is not true of other regulators according to the Secretary’s statement.

The full text of the statement, which includes other topics, is available here.

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On July 21st Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies by amending Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include greatly increased risk and reliability related disclosures in their ratings reports, and (5) file annual regulatory reports, including compliance certifications.  Among other topics, the mandated policies and procedures must address conflicts of interest in the rating process.

The proposal directs the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business pricing and business practices. This would amend the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration.

Our detailed analysis of the proposal is available here.

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A recent WSJ article reported that hedge funds are experiencing their best performance in a decade due, at least in part, to declining competition for market opportunities from proprietary trading by the major banks which have become more conservative.  This provides an explanation for a Morningstar report on July 21st that during the second quarter their index of 1,000 hedge funds had posted its best quarterly return at 9.25% since the inception of the index in 2003.  The prior best was just 7.40% in 2003.

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Yesterday the House voted to amend the 34 Act to give regulators the power to veto incentive-based pay packages at institutions with over $1B in assets when they find that the packages would induce excessive risk-taking.  The bill also mandates that shareholders of a registered company be given the opportunity to cast advisory votes on the company’s compensation practices.

In most cases, reform efforts have focused on giving more power over executive compensation to shareholders, but this legislation goes further, imposing limits overseen by regulators.  In an editorial in the Financial Times, Professor Bebchuk of Harvard Law School supports the proposal on the grounds that these shareholders benefit from explicit and implicit government guarantees, creating a moral hazard that they will be comfortable with more risk than is justified economically and therefore approve incentives that reward excessive risk taing.

A widget from OpenCongress that will track the progress of this bill is included at left.  Added information about the bill and links to sign up for alerts and other services for this or other bills are available on their site.

Following are the links to:

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Summary: Detailed analysis of the Treasury’s proposal to require Credit Rating Agencies to register with the SEC and implement enhanced compliance organizations, practices and disclosures.  Includes analysis of the actions the SEC is directed to take to implement the proposal.  A briefer entry is available here.

Last week the Department of the Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies, one of the groups that has been pointed to as contributing to the current financial crisis. The proposal would amend Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include increased risk-related disclosures in ratings reports, and (5) file annual regulatory reports, including compliance certifications.  The proposal also requires the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business practices thought to compromise the efficacy of the rating practice, as well as to detail the rules required to implement the Act.

This legislation builds upon the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration and were themselves extensions of earlier Commission efforts to increase the reliability of the ratings process through a series of no action letters.  The approach taken in the proposal to improve the conduct of the NRSROs mirrors regulatory provisions adopted over the past several years to tighten the governance and compliance environments in regulated broker/dealers, investment advisers and investment companies, including the development of written policies and procedures, the adoption of codes of ethics, the designation of Chief Compliance Officers, and the institution of systems of internal controls.  The specific concerns targeted in the proposal also reflect the increased focus that governance experts, like Professor Coffee at Columbia, have placed on dealing with conflicts of interest between the “gatekeepers” like the auditors and rating agencies and their clients, as the basis for structuring statutory and regulatory requirements.

On August 5th Professor Coffee testified before the Senate Committee on Banking, Housing and Urban Affairs concerning this proposal. In his opening statement, a clip from which is included at left, Professor Coffee points to two shortfalls in the Treasury proposal relative to legislation proposed in April by Senator Reed, which he believes would make the measure ineffective in remedying the problems it targets. First, the proposal fails to address the lack of due diligence reviews by the agencies of the inputs used in their models. Second, rating agencies don’t face the same risks of potential legal liability that motivates most other gatekeepers to adopt rigorous measures to verify the accuracy of their work products.

Concern with the reliability of credit ratings has been voiced by a number of firms and organizations in the investment industry, especially by those managing money market funds which are required to apply NRSRO ratings when selecting certain investments.  In April representatives from some of the leading investment firms, the industry groups, the NRSROs, and academia participated in an SEC roundtable on this issue.  While much of the discussion called either for a more dramatic restructuring of the industry at one extreme, or for much less change than the proposal includes at the other, depending mostly on the affiliation of the participant, there was clear agreement that change is required because the markets have lost confidence in the ratings being issued.  In his statement, Richard Baker (the President and CEO of the Managed Funds Association) noted the concerns of the alternative investment industry, described the agencies as playing a fiduciary role,  and called for regulators to require increased disclosure, greater transparency, and some form of accountability.

NRSRO Requirements

The Act directs the SEC to promulgate rules specifying how NRSROs are to manage conflicts that arise from business relationships, affiliations or board overlaps with the issuers they rate, from any affiliations among their staff and the issuers or underwriters of rated securities, and from any any other sources of conflict they identify.  Based on these rules, each NRSRO will be required to establish and enforce compliant written policies and procedures, reasonably tailored to their activities to identify, address and disclose conflicts of interest involving the agency or its staff, and to strengthen their governance procedures for managing such conflicts as may arise.

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Summary: Analyzes the Administration’s proposal to require registration with the SEC, added record-keeping, and filing of annual reports concerning investment practices and clients; includes an analysis of the potential impact of giving the SEC broad power to define terms (including ‘client’) in the Act. A briefer entry is available here.

On Wednesday July 15, the Administration released its widely-expected proposal to require most hedge fund advisers, and most other managers of pools of private equity, to register under the Advisers Act.

The proposal would immediately eliminate the exemption from Advisers Act registration for most hedge fund advisers to the extent of requiring them to register for purposes of imposing record keeping and reporting requirements.   A second consequence of the proposal, which is likely to have the larger long-term impact, is to clarify the power of the SEC to interpret the terms of the Advisers Act, including the term ‘client’, in effect granting the Commission the power to broadly eliminate the Advisers Act exemption, a power which the court found lacking in Goldstein vs. S.E.C..

Immediate Impact

The stated intent of the proposal is to require such record-keeping and reporting as the SEC deems necessary or appropriate: (1) in the general public interest, (2) for the protection of investors, or (3) for assessment of systemic risk.

Like the Commission’s overturned 2004 regulations that required hedge fund advisers to register, the proposed statutory language addresses advisers to ‘private funds’, where a private fund is defined as an investment fund that would be subject to the 40 Act but for the provisions of 3(c)(1) or 3(c)(7), which of course are the provisions relied on by funds exempt from registration under that Act.

Under the proposal, the SEC is authorized to require advisers to private funds to keep records of AUM, use of leverage, counterparty credit exposure, trading and investment positions, and trading practices – along with any other information the Commission determines to be necessary.  The Commission is given the power to determine the mandated record retention period and examination protocols.

By including position, trading and trade practice data, the reporting requirement will encompass much of the the core strategic information now closely held by the advisers.  The SEC is directed to treat the collected information as confidential, subject to the requirement to make it available to the FRB as required to identify those advisers which could pose a systemic risk (who would be designated Tier 1 FHCs).  The Commission also is required to provide confidential treatment to such information to the extent that it is included in its findings and reports, provided that it must disclose such information to the FRB and to such other government agencies and SROs as may require the information.

The proposal would also require advisers to provide added information to investors, prospects, counter parties and creditors in the form of such reports and information as the Commission may prescribe.

Finally, the amendment would explicitly strike the Section 210(c) provision of the Act that limited the Commission’s ability to require an adviser “to disclose the identity, investments, or affairs of any client.”  This again opens their access to strategically sensitive information.

Longer-Term Impact

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Proposed Private Fund Legistation

July 16, 2009

 PrintOn July 15 the Administration released proposed legislation that would require most hedge fund advisers and other managers of pools of private equity to register with the SEC for purposes of imposing new record keeping and reporting requirements tailored to the private funds.  Confidentiality of the filings is addressed in the proposal, but requirements for sharing […]

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InDepth: The Impact of Registration – Broadly

July 7, 2009
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 PrintSummary: Based on statements by the Administration and the SEC, analyzes potential consequences of requiring hedge funds and other managers of private funds to register with the SEC.  The analysis notes that proposal largely defers the details so that the impact will depend on the interpretations and enforcement that the SEC adopts after the legislation […]

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Background: OK, So What Exactly is a Hedge Fund?

July 6, 2009
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 PrintOver time I’ve found there’s a lot to be learned by exploring those questions that seem simple but require complicated answers, and defining a “hedge fund” falls squarely in that category. Therefore, I hope you’ll bear with me for an overly long post exploring this particular question. Beyond the simplistic, and not entirely accurate, explanation […]

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Welcome: (please excuse the construction)

June 30, 2009
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Introductory posting to introduce the Hedge Fund Regulation Blog.

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Regulatory Overview (and Index to postings on this Site)

January 24, 2009
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 PrintThe primary authority governing U.S. hedge fund advisers is found in the Investment Advisers Act of 1940 (generally called the Advisers Act), but additional requirements can arise under the Securities Act of 1933 (33 Act), the Securities Exchange Act of 1934 (34 Act), and the Investment Company Act of 1940 (40 Act). Depending on the […]

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