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Legislation Impacting Hedge Funds Starts Moving through the House

by Ron Diel on November 18, 2009

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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.



The 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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Wall Street Stop

Background: The Exemptions that Shaped the Hedge Fund Industry

by Ron Diel on August 24, 2009

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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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Geithner and Obama

InDepth: The Private Fund Investment Advisers Registration Act of 2009

by Ron Diel on July 16, 2009

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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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InDepth: The Impact of Registration – Broadly

by Ron Diel on July 7, 2009

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Summary: 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 is passed.

Given the administration’s proposed foundation for Financial Regulatory Reform, the presence of multiple bills in Congress, and the vocal acquiescence of the hedge fund industry itself, it appears certain that most hedge fund advisers will be required to register under the Advisers Act by year-end.  The prospects are sketchier, but comments from Mary Schapiro at the SEC and some of the legislative momentum indicate that the funds themselves may be required to register under the 40 Act.  Hedge Fund registration of either sort obviously isn’t an end in itself, however – the response of the industry and any cost/benefit assessments will depend on what is to follow registration.

For example, registration could be a precursor to having the regulators / SROs increase their oversight of individual hedge fund activity.  For the more visible recent problems like Madoff and Stanford Financial, however, the primary problem seems to have been gaps in the effectiveness of the oversight performed in its ability to achieve the twin goals of protecting investors from abuses and protecting the system from catastrophic risks.

The secondary problem has been the high compliance cost imposed on registered entities to achieve these limited benefits, as documented in SIFMA’s study of the Costs of Compliance in the securities industry. The recent scandals clearly undercut many assumptions underlying the asserted value of the hedge fund regulation already in place.

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