Wednesday, January 05, 2011

In Letter to SEC, Hedge Fund Industry Opposes SRO for Investment Advisers

The hedge fund industry vigorously opposes an SRO for investment advisers. In a letter to the SEC, the Managed Funds Association said that an SRO for private fund managers would only perform a function that is already being performed effectively by the SEC and could even diminish the quality of regulation of fund managers. The letter was occasioned by Section 914 of Dodd-Frank, which requires the SEC to study the extent to which the establishment of an SRO to augment the Commission’s oversight of investment advisers would improve the frequency of examinations of advisers. Private fund managers are subject to SEC regulation as investment advisers under the Investment Advisers Act, which applies broadly to an advisory firm’s investment activities and relationship with clients.

According to the MFA, there is currently no organization with the extensive knowledge of the industry, and experience in interpreting and applying the Advisers Act and its rules to private fund managers that would be necessary for adviser industry SRO status. Further, an
SRO’s lack of experience in overseeing private fund managers could lead to inconsistent regulation and uncertainty for managers in operating their businesses.

In particular, the nature of the Advisers Act as a principles-based statute would present difficult challenges to a new SRO or one with only experience in administering a rules-based regulatory framework. Moreover, an SRO overseeing both private fund managers and other types of firms would face difficult conflicts of interest in overseeing all of its members fairly and equitably. Private fund managers are active participants throughout the securities markets, noted the MFA, and interact with other financial firms in numerous capacities, including engaging them as service providers to funds they manage, entering into counterparty arrangements with them, and competing with them for investment opportunities.

An example of the type of interactions that could give rise to potential conflicts of interest for an SRO is the relationships between private fund managers and brokerage firms. In implementing their investment strategies, hedge fund managers engage one or more broker-dealer firms to serve as a prime broker for funds they manage. Prime brokers provide a number of important services to hedge funds, including custody of assets, clearing of securities transactions, securities lending, financing and reporting.

In addition, hedge fund managers enter into arrangements with brokerage firms in which they serve as a counterparty to a financial transaction with the hedge fund. While counterparty arrangements take various forms, depending on the type of financial transaction, each arrangement is an arms length transaction between a fund manager and a brokerage firm in which the interests of the two parties are generally not aligned. The features of prime brokerage and counterparty arrangements are complex, observed the MFA, and hedge fund managers and broker-dealers generally negotiate their terms. The MFA fears that the overlapping and competing interests between hedge fund managers and brokerage firms created by these arrangements would present challenges to an SRO responsible for overseeing these types of firms fairly and equitably.

In addition, the MFA posited that the expense of establishing a new SRO would exceed the cost of providing additional resources to the SEC’s current examination and inspection regime. The private fund industry is small and an SRO would not benefit from economies of scale that would reduce costs to a wider membership. Because many private fund managers are also relatively small firms, fees paid to an SRO would constitute a higher percentage of revenue than other industries.

It is also compelling that the activities of private fund managers are already subject to comprehensive, long-standing federal securities laws and regulatory oversight. The current SEC-administered framework subjects private fund managers to oversight with respect to their trading and investment activities, their effects on markets and financial stability, and their management of client assets. In its entirety, this framework applies to all areas of a private fund manager’s business, including securities and derivatives trading activities, the effects of its investment activities on financial stability, registration with the SEC, and the protection of investors, and leaves no gaps in oversight. In addition to the areas of SEC regulation, hedge fund managers are subject to a number of other rules, including, among others, those adopted by the CFTC, the Department of Labor, and Treasury.

In contrast, said the MFA, policy makers in the past established existing SROs for the financial services industry in response to incomplete or ineffective regulatory environments. For example, the precursor to the NASD was developed in the 1930s in response to the need to regulate the over-the-counter securities markets, whose lack of regulation at the time created a significant gap in the regulatory scheme. The existing framework for the regulation of private fund managers leaves no such gap to be filled by an SRO.

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