Against the backdrop of pending legislation to require the SEC registration of hedge fund advisers, Andrew Donohue, the director of the Division of Investment Management, told the Senate Subcommittee on Securities that the Commission strongly believes that legislative action is needed to increase regulation of hedge funds and other private investment pools. These funds play a significant role in the capital markets, he said, but the Commission has limited information about them. The SEC attempted to close the regulatory gap with a rulemaking initiative in 2004, but it was overturned in a court challenge. Mr. Donohue said the SEC supports the approach outlined in the Private Fund Transparency Act of 2009, S. 1276, and there are other approaches that would also close the regulatory gap.
The Private Fund Transparency Act, introduced by subcommittee chair Sen. Jack Reed, would require advisers to private funds to register under the Investment Advisers Act if they have at least $30 million of assets under management. The Act would eliminate Investment Advisers Act Section 203(b)(3) which provides an exemption from registration for advisers with fewer than 15 clients that do not hold themselves out to the public as investment advisers. The Commission believes that Section 203(b)(3) was originally designed for advisers that were too small to warrant federal attention, but it is now used by advisers with billions of dollars under management. These advisers are able to claim the exemption because each fund is counted as a client.
The Director also noted that the Reed legislation includes some important amendments to the Advisers Act that are critical to the SEC’s ability to collect information from advisers about private funds, including amendments to Section 204 of the Act permitting the Commission to keep information collected confidential, and amendments to Section 210 preventing advisers from keeping the identity of private fund clients from SEC examiners
The SEC's 2004 rulemaking initiative required hedge fund advisers to look through each fund to count the number of investors in the fund as clients in determining whether the adviser met the Section 203(b)(3) exemption. When the rule was overturned by a federal appeals court (Goldstein v. SEC (D.C.Cir. 2006)), about 800 hedge fund advisers which had registered with the SEC withdrew their registration.
The registration of hedge fund advisers would be beneficial to investors in many ways, in the SEC's view. Registered advisers would have to provide complete information to the Commission. The staff could conduct on-site examinations to ensure that these advisers are fulfilling their fiduciary duties and are either avoiding or fully disclosing any conflicts of interest. The staff could oversee the advisers' trading activities to prevent market abuses such as insider trading and market manipulation.
Registered advisers must develop internal compliance programs administered by a chief compliance officer. Compliance officers serve as the front-line in watching for violations of securities laws and conflicts of interest. The SEC believes that investment adviser registration is appropriate for those managing $30 million in assets regardless of the type of client or the securities in which the advisers invest.
One alternative to adviser registration is to also register private funds under the Investment Company Act, or the Commission could be given the authority to impose requirements on unregistered funds. Another option is, in conjunction with adviser registration, to provide the SEC with flexible regulatory authority to respond to industry developments. This flexibility is needed, reasoned the Director, because it is difficult to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as private funds.
This could be done by providing rulemaking authority to condition the use by a private fund of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. These conditions could impose those requirements that the Commission believes are necessary or appropriate to protect investors and enhance transparency For example, private funds might be required to provide information directly to the Commission. These conditions could be included in an amendment to the Investment Company Act or could be in a separate statute.
The Director acknowledged that any new responsibilities would require additional resources in order to be effective. Sen. Jim Bunning (R-KY) questioned the SEC's ability to hire personnel with the level of knowledge necessary to regulate the highly complex industry. While acknowledging that it is a challenge, the Director said that the SEC is reaching out to people with the right skill sets. Sen. Bunning was skeptical about the SEC's ability to hire people with the necessary expertise for $150,000, but Mr. Donohue said the SEC has had some success.