The Obama Administration has asked Congress to pass legislation requiring SEC registration of advisers to hedge funds and other private pools of capital, including private equity funds and venture capital funds, with assets under management over a certain threshold. All such funds advised by an SEC-registered investment adviser should be subject to investor and counterparty disclosure requirements and regulatory reporting requirements.
The rules should require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability. The SEC should share the reports that it receives from the funds with the entity responsible for oversight of systemically important firms, which would then determine whether any hedge funds could pose a systemic threat and should be subjected to the prudential standards administered by the systemic risk regulator.
The legislation should require the SEC to share the reports it receives from hedge funds with the Fed so that the Fed can determine if the funds or fund families pose a systemic risk and thus become subject to Tier 1 financial holding company regulation.
The Administration’s proposal is broadly in line with proposals advanced by the G-20 and the Scott Report, which recommended the adoption of a confidential reporting requirement pursuant to which each hedge fund would be required to register and provide a regulator with information relevant to the assessment of systemic risk. Confidential reporting would involve information addressing, among other things, a fund’s liquidity needs, leverage, return correlations, risk concentrations, connectedness, and other relevant sensitivities.
However, the regulator would bear the burden of demonstrating its need for the required information as well as its ability to use that information effectively. The regulator also would have limited authority to take prompt action in extreme situations where a hedge fund poses a clear and direct threat to market stability.
Because many hedge funds fall within certain exemptions of the Investment Company Act of 1940 and the Investment Advisers Act of 1940, those hedge fund are required neither to register with the SEC nor to disclose publicly all their investment positions.
The Administration’s proposal was not written on a blank slate. The SEC took the first step in this direction with the issuance of a rule requiring hedge fund managers to register with the Commission as investment advisers pursuant to the Investment Advisers Act. But a federal appeals court later vacated the rule.
In a 2006 case, a panel of the District of Columbia Circuit Court of Appeals declared arbitrary an SEC rule requiring hedge fund managers to register with the SEC if they had more than fourteen clients and managed a specific amount of assets. The Investment Advisers Act exempts from registration those investment advisers with fewer than fifteen clients. The court rejected the SEC’s suggestion of counting the investors in the hedge fund as clients of the fund’s adviser in order to get over the fourteen client limit.That decision effectively ended all registration of hedge funds with the SEC, unless and until Congress acts. Goldstein v. SEC (CA DofC 2006), 451 F3d 873.
Currently, there is pending legislation in Congress designed to close the loophole created by the Investment Advisers Act of 1940, which exempts hedge fund advisers from registering with the SEC if they have less than 15 clients. The Hedge Fund Adviser Registration Act, HR 711, would require anyone who manages hedge funds to register with the SEC. A companion bill in the Senate, the Hedge Fund Transparency Act, S 344, would impose registration and periodic disclosure requirements on hedge funds essentially the same as the regulation of traditional investment companies.
The Hedge Fund Transparency Act would require hedge funds to register with the SEC, file an annual public disclosure form with basic information, and cooperate with any SEC information request or examination. Public disclosures pursuant to the Act would include a listing of beneficial owners, a detailed explanation of the fund’s structure, an identification of affiliated financial institutions, as well as the number of investors and the fund’s value and assets under management.
European Union
In Europe, the European Commission favors the identification of hedge funds that are of systemic importance, and imposing on them reporting requirements that provide a clear ongoing view of the strategies, risk structure and leverage of these systemically-important funds. In the UK, the Turner report, by the Financial Services Authority Chair Adair Turner, similarly highlights the need to gather much more extensive information on hedge fund activities in order to understand overall macro prudential risks.
Anticipating similar legislation in the US, and in a move that could prevent regulatory arbitrage, the European Commission proposed the broad regulation of managers of hedge funds and all private equity funds with 100 million euros of assets under management. The Directive on Alternative Investment Fund Managers is designed to create a comprehensive and effective regulatory framework for hedge and private equity fund managers at the European level.
The proposed Directive will provide robust and harmonized regulatory standards for all alternative investment funds within its scope and enhance the transparency of the activities of the funds towards investors and public authorities. This will enable Member States to improve the macro-prudential oversight of the sector and to take coordinated action as necessary to ensure the proper functioning of financial markets. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.
There had been some confusion over whether just hedge funds, and not private equity funds, would be included in the proposed Directive. In the end, the Commission opted for the broad regulation of all alternative investment funds over a certain minimum asset management level. The Commission was loath to attempt to define hedge funds, fearing that many systemically relevant funds may fall through a regulatory gap. The proposed Directive parallels the proposal presented by the Obama Administration to Congress, which would federally regulate both hedge funds and other private equity funds.
Fully acknowledging the need for harmonized fund regulation, the Commission anticipates similar US legislation later this year.In order to operate in the European Union, all hedge funds and private equity funds will have to be authorized by their home state regulator. They will have to demonstrate that they are suitably qualified to provide fund management services and will be required to provide detailed information on the planned activity of the fund, the identity and characteristics of the assets managed, the governance of the fund, including arrangements for the delegation of management services, arrangements for the valuation and safe-keeping of assets.
The alternative investment funds would also be required to hold and retain a minimum level of capital.To ensure effective risk management of hedge fund activities, the funds will be required to satisfy their regulators of the robustness of their internal risk management procedures, in particular liquidity risks and additional operational and counterparty risks associated with short selling. They will also have to set forth procedures for the management and disclosure of conflicts of interest and the fair valuation of assets.Disclosure is a centerpiece of the proposed regime.
Hedge and private equity funds would have to disclose to investors their investment policy, including descriptions of the type of assets and their use of leverage. They would also have to disclose their redemption policy in both normal and exceptional circumstances, as well as their fees and expenses. The funds would also have to disclose their risk management and valuation procedures. The funds would be required to disclose to regulators the principal markets and instruments in which they trade, as well as their principal exposures, performance data and concentrations of risk.