PrintSummary: 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
The proposal goes on to ‘clarify’ the rulemaking authority of the SEC. In particular, the Commission is authorized to interpret the definition of all terms in the Advisers Act, specifically including the term ‘client.’ When the SEC last tried to require registration of hedge funds in 2004, they did so by reinterpreting ‘client’ to mean investors in the fund, not the hedge fund itself, meaning that virtually all hedge fund advisers would exceed the 15-investor limit on the 203(b)(3) exception to registration. In Goldstein vs. SEC, however, the Court found that the Commission lacked the clear authority to change this interpretation and, on that basis, invalidated the requirement.
Based on this history, the impact of this portion of the proposal would be to allow the SEC to once again require hedge funds to register under the Advisers Act, effectively nullifying the basis for the the Court’s finding in Goldstein (as you’d expect given the use of the term ‘clarify’ in the proposal). This clears the way for the SEC to reintroduce the hedge fund registration requirements it adopted in 2004. As with that earlier attempt to regulate these advisers, by dropping their exemption the Commission would impose all of the requirements of the Advisers Act upon them, including potential limitations on compensation and the administratively complex requirement to adopt extensive policies and procedures detailing their internal controls. Beyond this, the Commission will also have the opportunity to impose new requirements if deemed appropriate.
The proposal also makes it clear that the Commission has the authority to vary requirements under the Act for different classes of person or different situations, opening the possibility of tiered regulations based on adviser size, client base or strategy. Thus, as we’d speculated in an earlier posting ( The Impact of Registration ), it appears that the real impact of the Administration’s proposals will be determined by the detailed requirements developed in part by the Congress, but more likely by the SEC following the adoption of amendments to the Advisers Act.
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Ron -
I am not a big fan of this approach. I am concerned about twisting the definition of “client” along the same reasoning as the Goldstein case that overturned the the old Hedge Fund rule.
I think the Hedge Fund Adviser Registration Act of 2009 does a better job by just removing the 15 client rule exemption of removing the exemption for private funds over a certain dollar amount.
Doug,
Thanks for this comment – I understand your preference: more specificity in the proposed language certainly would make it both easier to comply going forward and clearer what the real intent of the Act was – right now this part remains a bit opaque.
Inferring the genesis of the proposed language from its structure, I find the amendment specific about hedge funds being subject to the information gathering capabilities that the proposed Financial Services Oversight Council, the FRB and other agencies will likely need for their planned roles – probably at their request. On the other hand, it merely tries to clear any roadblocks to let the SEC address its own roles and concerns via their rulemaking process – as they also probably requested.
Perhaps, the second thrust should have been clearer and more specifically channeled in the proposed language, but in the current push to legislate they may not have wanted to take the time to determine the right scope of coverage (by AUM, clients, other factors, or a mix). When a court interprets a statute, it’s always open to Congress to “clarify” the meaning as the proposal would do, although so far it is of course just the Executive Branch proposing to keep the authority to set the details within its own agency. We’ll see how Congress responds.
From a theoretical perspective, there is a case for using the rulemaking powers of an agency to address complex topics that require more expertise and/or flexibility than the Legislative Branch can devote – and this topic may well qualify. Nevertheless, it would have been good to be more specific if this is the intent.
I agree that lots of the details should be left to the SEC and its rule making powers. I have resigned myself to the likelihood that my company will now be subject to disclosures to and examination by the SEC.
Another big concern is how the SEC is going to handle all of this extra workload. I would guess that this law will double the number of companies that the SEC has to review.
Doug, I agree with your concerns – it’s been all too publicly visible over the last year that there were major gaps in the SEC’s oversight before so an added workload will be an issue.
The bad news is that they’re likely to try to fill that gap by continuing to push more responsibility onto the hedge funds’ compliance officers in the form of added oversight and documentation requirements arising from imposing and strictly enforcing regulations like 206(4)-7 (perhaps going further to detailed reporting requirements like 38a-1 of the 40 Act). The problem is that the mid-sized and smaller hedge funds this Act would affect lack the staff and infrastructure larger firms use to do this and, moreover, really don’t have a business model or culture that will support diverting the time of front office people from chasing alpha (and clients) to performing the administrative parts of the oversight roles you’ll need them to play in order to capture the required paper trail of approvals and supervision (let alone the work to set up the supervisory framework). I know these managers can and do watch closely, but up until now the size of the firms has let them supervise more closely than larger firms even though they’ve been less formal about it.
Beyond the disruption, even the significant added cost could be a problem for advisers where market concerns, high water marks and client pressure are chopping into performance fees.
My sense is that this will really squeeze the smaller firms that get swept into the new regulations, forcing them to rethink their independence (or scale back to fit under the new limits).
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