Hedge Fund Industry Supports Draft Legislation Regulating Advisers to Hedge and Private Equity Funds

The hedge fund industry generally supports draft legislation in the House Financial Services Committee requiring advisers to hedge funds and private equity funds to register with the SEC. Vetted by Rep. Paul Kanjorski, Chair of the Capital Markets Subcommittee, the Private Fund Investment Advisers Registration Act would mandate the registration of private advisers to hedge funds and other private pools of capital and impose new recordkeeping and disclosure requirements on private advisers in order to provide regulators the information they need to evaluate both individual firms and entire market segments.

In testimony before the committee, the MFA said that applying the registration requirement to currently unregistered investment advisers to all private pools of capital, instead of just hedge fund managers, is a smart approach to this type of reform. Removing the current exemption from registration for advisers with fewer than fifteen clients would be an effective way to achieve this result. Further, the MFA believes that the Investment Advisers Act provides a meaningful regulatory regime for registered investment advisers. The responsibilities imposed by the Advisers Act are not taken lightly and entail significant disclosure and compliance requirements

The MFA urges Congress to include a narrowly tailored de minimis exemption from registration for the smallest investment advisers that balances the goal of a comprehensive registration framework with the economic realities of small investment advisers. Regulatory resources, capabilities and structure should also be considered as policy makers determine an appropriate de minimis threshold. Congress should also ensure that any approach in this regard is consistent with state regulation of smaller investment advisers and avoids duplication

While the MFA declined to propose a specific de minimis amount, the group encouraged Congress to determine an amount that is not so high as to create a significant loophole that undermines a comprehensive registration regime, and not so low that the smallest investment advisers are unable to survive because of regulatory costs.

The MFA also cautioned that legislation should not impose limitations on the investment strategies of private pools of capital. As such, regulatory rules on capital requirements, use of leverage, and similar types of restrictions on the funds should not be considered as
part of a regulatory framework for private pools of capital.

It is critical that regulators keep confidential any sensitive, proprietary information that market participants report. Public disclosure of such information can be harmful to members of the public that may act on incomplete data, said the MFA, and could harm the ability of market participants to establish and exit from investment positions in an economically viable manner. Regulations should not force market participants publicly to reveal information that would be tantamount to revealing their trade secrets to competitors.

Similarly, the SEC should share reported information with foreign regulators only under circumstances that protects the confidentiality of that information. For example, the SEC has adopted Exchange Act Rule 24c-1 allowing the Commission in its discretion to share nonpublic information with a foreign financial authority if the authority receiving the information provides assurances of confidentiality as the Commission deems appropriate. The MFA urged the SEC and other US regulators to employ this type of approach when sharing information with foreign regulators.

The MFA also urged Congress to construct the new regulatory regime in a way that distinguishes between different types of market participants and different types of investors or customers to whom services or products are marketed. One notable distinction that should be retained is between private sales of hedge funds to sophisticated investors under the SEC’s private placement regime and publicly offered sales to retail investors. This distinction has been in existence in the United States for over 75 years, noted the MFA CEO, and has proven to be a successful framework for financial regulation. The MFA strongly believes that regulation that is appropriate for products sold publicly to retail investors is not necessarily appropriate for products sold privately to only sophisticated investors.

A specific concern of the MFA is the elimination of the current exemption from SEC registration in section 203(b)(6) of the Advisers Act, for commodity trading advisors registered with the CFTC. This change would create unnecessary, duplicative and costly requirements for those advisors.

This is a limited exemption for commodity trading advisors for CFTC registered advisors who do not primarily act as an investment adviser. This exemption does not create a regulatory gap, said the MFA, nor does it leave advisers to private funds outside of a registration framework. Rather, it ensures that CTAs to private funds, which are primarily engaged in the business of providing advice regarding futures and are already subject to comprehensive regulation do not have to be subjected to a dual registration and regulatory framework.

The MFA is also concerned that the delegation of authority to the SEC to define the term “client” is overly broad. There is concern with respect to an adviser’s fiduciary obligations to its clients, specifically with imposing fiduciary obligations on an adviser with respect to investors in pooled investment funds managed by that adviser.

An adviser to a pooled investment fund likely would not have the information about the underlying investors in the fund necessary to be able to determine whether an individual investment made for a fund’s portfolio would also be appropriate for an individual investor. Further, applying fiduciary obligations to the investor and the fund can create potential conflicts between an adviser’s obligations to the fund and obligations to investor.

There is further concern about imposing disclosure to counterparties on private fund managers that do not apply to any other financial institutions. It is unclear to the MFA how disclosure from a private fund adviser to its counterparties raises either investor protection or systemic risk concerns. Counterparties are not investors, emphasized the MFA, they are sophisticated market participants capable of protecting their own interests in negotiating a transaction.

There must also be some limitations on the types of information that an investment adviser should be required to disclose to other market participants. For example, the MFA would oppose a requirement that broadly forces an investment adviser to reveal its proprietary trading strategies or algorithms.

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