On July 15, 2009, the Obama administration (the “Administration”) delivered to Congress draft legislation, the Private Fund Investment Advisers Registration Act of 2009. Under the proposed legislation, managers of most hedge funds, private equity funds and venture capital funds in the U.S. would be required to register with the Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The existing exemption for investment advisers with fewer than 15 clients would be eliminated, and specific information reporting would be required for advisers to any “private fund.” A limited exemption will continue to apply to certain “foreign private advisers.” The existing threshold of $30 million of assets under management for mandatory SEC registration would continue to apply.
Andrew Donohue, the SEC’s Director of Investment Management, discussed these and other potential regulatory reforms in his testimony on July 15, 2009, before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs concerning the regulation of hedge funds and other private investment pools.
Applicability to Advisers to Private Funds
The new reporting requirements will generally apply to investment advisers to any “private fund,” which would be any investment fund that is relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 for exemption from registration, and that is either organized in or created under the laws of the U.S. or has 10 percent or more of its outstanding securities owned by U.S. persons.
Additional Reporting to the SEC
In addition to the existing regulatory obligations of registered investment advisers to private funds, the draft legislation would require all registered investment advisers to private funds (including newly registered advisers) to submit reports to the SEC as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Federal Reserve Board (the “Federal Reserve”) and the proposed Financial Services Oversight Council (the “FSO Council”).
The reports would include at least the following information for each private fund:
1. Amount of assets under management;
2. Use of leverage, including off-balance sheet leverage;
3. Counterparty credit risk exposures;
4. Trading and investment positions;
5. Trading practices; and
6. Such other information as the SEC and the Federal Reserve determines are necessary or appropriate.
These records and reports would be deemed records and reports of the investment adviser, which would be required to maintain and keep them in accordance with retention requirements prescribed by the SEC. The SEC would be required to make the new systemic risk data and reports available to the Federal Reserve and the FSO Council. In addition, because the private fund’s records would be deemed records of the investment adviser, they would be subject to periodic examination by the SEC and its staff.
Although the draft legislation provides that the SEC would not be required to disclose the reports or their content, the SEC would not be permitted to withhold information from Congress or any federal agency or self-regulatory authority. Accordingly, confidentiality would not be completely safeguarded.
New Requirements for Disclosures to Investors and Counterparties
The Administration also proposes to require investment advisers to provide additional reports, records and other documents to investors, prospective investors, counterparties and creditors relating to any private fund. The SEC would prescribe these disclosure requirements “as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.” The rulemaking process will provide an opportunity for notice and comment before these new requirements are adopted.
Disclosure of Client Data
Currently, Section 210(c) of the Advisers Act prohibits the SEC from requiring investment advisers who provide “investment supervisory services” (i.e., “continuous advice as to the investment of funds on the basis of the individual needs of each client” ) to disclose the identity, investments, or affairs of any client, except in connection with an enforcement proceeding or investigation. That section, which provides some basic protection of client data, would be eliminated. This would allow the SEC to adopt rules requiring the disclosure of such information.
• Foreign Private Advisers
Section 203 would retain the fewer-than-15 client exemption for “foreign private advisers,” if the investment adviser meets all of the following requirements:
A. it has no place of business in the United States;
B. during the preceding 12 months it had (i) fewer than 15 clients in the United States and (ii) assets under management attributable to clients in the United States of less than $25,000,000 (or such higher amount as the SEC may prescribe); and
C. it does not generally hold itself out in the United States as an investment adviser, and is not an investment adviser to a registered investment company or business development company.
If enacted as proposed, the legislation would potentially bring into the ambit of U.S. registration for the first time many non-U.S. advisers that have contacts with the U.S. solely by virtue of having only a few U.S. clients.
• Intrastate Advisers
The current intrastate exemption in Section 203(b)(1) , for investment advisers whose clients are residents of the state within which the adviser has its principal office and place of business, would no longer be available to investment advisers to private funds.
Added SEC Powers
In direct response to the Goldstein decision, the administration proposes to amend Advisers Act Section 211 to allow the agency to ascribe different meanings to terms used in the Act (specifically the term “client”), and to prescribe different regulations for different classes of persons or matters within its jurisdiction.
Commodity Pool Operators
Finally, the SEC and the Commodity Futures Trading Commission (the “CFTC”) would be directed to work together to rationalize and develop joint proposals for the regulation of managers who are registered both as investment advisers with the SEC and commodity pool operators with the CFTC.
Issues to Consider
At this early stage, of course, only the broad framework of the Administration’s plan is available. As the specific requirements take shape, the following issues, drawn largely from Mr. Donohue’s testimony, should be kept in mind:
• Registration of Funds. Although Mr. Donohue noted that the SEC’s preferred approach to closing regulatory gaps created by unregistered private funds is to require registration of the funds’ advisers, he also discussed the option of giving the SEC direct authority over private funds themselves. This could be accomplished either by requiring the funds to register under the Investment Company Act of 1940, or by giving the SEC authority to regulate unregistered funds. Mr. Donohue posited that this could allow the SEC to impose investment restrictions or diversification requirements on the funds, rather than leaving such decisions to the adviser’s investment discretion and fiduciary duty, and the mandate of the fund’s board or investment committee. Of even greater concern was the suggestion that the SEC could regulate the structure of private funds, such as by requiring an independent board of directors, and dictate investment terms, particularly with respect to redemption rights.
• Self-Regulation. Still left unanswered is the issue of self-regulation for investment advisers. Mr. Donohue’s testimony, however, signals that the SEC favors increased funding to allow it to carry-out its added responsibilities with respect to obtaining information and conducting on-site examinations, and is not seeking to import the self-regulatory construct to investment adviser regulation.
• Exam Protocols. Among other things, Mr. Donohue’s testimony indicates that SEC examinations of private fund advisers would focus on information that private fund investors are not able to determine themselves, such as full and accurate disclosure of conflicts of interest, and verification of custodied assets. Although the SEC has already modified its exam protocol in light of the Madoff situation, additional changes are likely to follow from any new authority and may, at least initially, be overbroad as the staff develops the experience and expertise required to more fully understand the activities and operations of advisers to private funds.
• Regulation of Trading Activities. In his testimony, Mr. Donohue notes that “[r]egistration of private fund advisers under the Advisers Act would permit oversight of adviser trading activities to prevent market abuses such as insider trading and market manipulation, including improper short selling.” This reference to heightened regulation likely refers to the new direct authority that the SEC would have to obtain information about private fund advisers through the inspections and examination process, rather than through the more formal enforcement process. It is possible, however, that the SEC could adopt prospective rules under the Advisers Act that would limit the trading and other activities of private fund advisers.