Monday, September 19, 2011

Hedge Fund Industry Opposes Legislation Authorizing SRO for Investment Advisers

The US hedge fund industry opposes legislation authorizing an SRO for investment advisers and believes that the existing framework of SEC regulation of private fund managers, as enhanced in a number of respects by the Dodd-Frank Act and regulatory implementation of the Act, is effective and should remain place. In testimony before the House Financial Services Committee, Managed Funds Association head former US Representative Richard Baker said an SRO would lack experience in regulating private fund managers, create inconsistent regulation, face difficult conflicts of interest, and ultimately diminish the quality of regulatory oversight of the private fund industry.

The former Chair of the House Capital Markets subcommittee noted that an effective private fund industry SRO must have extensive knowledge of the industry, and experience in interpreting and applying the Investment Advisers Act and its rules to private fund managers. The MFA is not aware of any organization with these necessary competencies, and thus is concerned that 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 an SRO that instead has experience in administering a rules-based regulatory framework.

Moreover, the creation of an SRO for private fund managers could subject a single advisory firm, such as a private fund manager or a traditional asset management firm that manages private funds in addition to other types of accounts, to two different regulatory frameworks. The MFA is concerned that these results would create uncertainty, and could have the unintended consequence of leading to an uneven playing field among advisory firms.

Even more compelling, the MFA said that 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. 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 broker-dealer firms. In implementing their investment strategies, hedge fund managers engage broker-dealer firms to serve as prime brokers and counterparties to funds. As prime brokers, broker-dealers provide a number of important services to hedge funds, including custody of assets, clearing of securities transactions, and securities lending. As counterparties, broker-dealers enter into arrangements with hedge funds in which they agree to make or receive payments to or from the fund based on certain market factors, such as the performance of an underlying asset.

While counterparty arrangements take various forms, depending on the type of financial transaction, each arrangement is an arm’s length transaction between a fund manager and a broker-dealer in which the interests of the two parties are generally not
aligned. The features of prime brokerage and counterparty arrangements are complex, noted former Rep. Baker, and hedge fund managers and broker-dealers generally negotiate their terms. The overlapping and sometimes competing interests between managers and broker-dealers treated by these arrangements would present challenges to an SRO responsible for overseeing these types of firms fairly and equitably. While acknowledging that existing SROs seek to address these types of concerns through their governance process and other methods, the MFA believex that oversight of private fund managers would lead to inherent structural difficulties in the operation of an SRO.

Finally, the MFA observed that a structure in which an SRO was given authority to inspect and examine private fund managers, and the SEC retained policy making authority, would add an extra layer of regulation for managers to comply with the Advisers Act. This dual regulatory structure would raise the risk of managers being confused as to how to comply with guidance from both entities, and could also lead to inconsistent policies, feared the MFA.