Acting on Obama Proposal, House Legislation Would Regulate Hedge Funds and Private Equity Funds

The Obama Administration 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. The Administration’s proposal is broadly in line with proposals advanced by the G-20, which recommended the adoption of a confidential reporting regime pursuant to which hedge funds would be required to register and provide a regulator with information relevant to the assessment of systemic risk.

Because many hedge funds fall within certain exemptions of the Investment Company Act and the Investment Advisers Act, those hedge fund are required neither to register with the SEC nor to disclose publicly all their investment positions.

The exemption has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the financial markets. As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to the broader markets and the economy. Thus, hedge funds and other private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection.

Legislation passed by the House Financial Services Committee requires investment advisers to hedge funds and other private investment funds to register with the SEC if they have assets under management of at least $150 million and be subject to significant disclosure and other requirements. Current law generally does not require private fund advisers to register with any federal financial regulator. The $150 million assets under management threshold is significantly higher than the $30 million trigger proposed by the Obama Administration.

The legislation accomplishes the registration of hedge fund advisers by eliminating the Investment Adviser Act’s private adviser exemption, which exempts from registration investment advisers that have fewer than 15 clients, do not hold themselves out to the public as investment advisers, and do not act as investment advisers to registered investment companies.

The legislation creates a limited exemption for foreign private fund advisers. The legislation mandates the registration of private advisers to private pools of capital so that regulators can better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole. In addition, new recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries. Under the legislation, advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in the capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

The legislation authorizes the SEC to require registered investment advisers to maintain records of, and submit reports about, the private funds they advise in two instances. First, as the SEC determines to be necessary or appropriate in the public interest and for the protection of investors; and second, as the SEC determines in consultation with the Federal Reserve Board, and to any other entity that the SEC identifies as having systemic risk responsibility, such as the new Financial Services Oversight Council, are necessary for the assessment of systemic risk. The records and reports of any private fund are further deemed to be the records and reports of the registered investment adviser.

The records and reports of hedge funds and other private equity funds must include information on the amount of assets under management, the use of leverage, including off-balance sheet leverage, counterparty credit risk exposures, trading and investment positions, and trading practices. As a catch all, the SEC, after consultation with the Federal Reserve Board, may require additional information that it deems necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

Similarly, the SEC is also authorized, after considering the public interest and potential to contribute to systemic risk, to set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds advised by such advisers.

The information that hedge funds and private funds disclose to the SEC will be confidential, except that the Commission may not withhold information from Congress. Also, the SEC is authorized to provide the information to the Fed and the new systemic risk regulator, the Financial Services Oversight Council, which in turn must keep the information confidential in a manner consistent with the confidentiality regime established by the SEC. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk.

This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to overall financial stability and should therefore be under the broad oversight of the new federal systemic risk regulator.

The legislation sets forth requirements related to the maintenance of records and the periodic and special examination by the SEC of such records. Investment advisers must also make available to the SEC or its representatives any copies or extracts from such records as may be prepared without undue effort, expense, or delay as the SEC may reasonably request

The SEC is also authorized to require investment advisers to provide reports, records and other documents to the investors, prospective investors, creditors, and counterparties of the private funds they advise. The SEC cannot be compelled to disclose any report or information contained within such report filed with the SEC, but the SEC may not withhold such information from Congress.

The Investment Advisers Act is amended to remove a provision that generally bars the SEC from requiring investment advisers to disclose the identity, investments, or affairs of their clients.

The Meeks-Peters-Garrett Amendment requires hedge fund advisers covered by the asset under management threshold exemption to maintain the required records and gives the SEC the discretion to require reports in the public interest or for investor protection. The Amendment also provides that, in adopting regulations for investment advisers to mid-sized private funds, the SEC must take into account the size, governance and investment strategy of the funds in order to ascertain if they pose a systemic risk to the financial markets. Then, the SEC must provide registration and examination procedures for the investment advisers reflecting the level of systemic risk posed by the finds they advise.

The House legislation also contains a registration exemption for advisers to venture capital funds. The SEC is directed to identify and define the term venture capital fund and provide an adviser to such a fund an exemption from the registration requirements. But the Commission must require advisers to venture capital funds to maintain records and provide annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.

An important amendment offered by Committee Ranking Member Spencer Bachus is designed to protect the fiduciary obligations that investment advisers owe their clients. The legislation gives the SEC the ability to define the term "client" of an investment adviser in a broad manner. Rep. Bachus believes that clarifying this language is necessary to avoid unintended consequences. Thus, the Bachus Amendment clarifies that the SEC cannot define the term "client" to include investors in a private fund managed by an investment adviser when that private fund has also entered into an advisory contract with the same adviser. The Amendment would prevent advisers from being subjected to an irresolvable conflict of interest when they manage a pooled investment with the interest of each individual investor in mind.

An amendment offered by Rep. Bachmann would require the SEC to enter into a formal rulemaking process to provide guidance to hedge funds, private equity firms, and other private pools as they adjust to the legislation’s new registration requirements.

An amendment by Rep. Garrett would require the US Comptroller General to conduct a study and report to Congress within two years on the costs to the hedge fund industry of the legislation’s registration and reporting requirements. Another amendment offered by Rep. Kosmas would delay the effective date for one year, although advisers would have the discretion to register earlier with the SEC.

The legislation clarifies the SEC’s rulemaking authority by allowing the Commission to make rules necessary for the exercise of the powers it is granted under the Advisers Act. This rulemaking authority includes power to give different meanings to terms, including “client,” used in different sections of the Act. Additionally, the SEC and the CFTC are directed to jointly promulgate rules to establish the form and content of required reports for investment advisers registered dually under the Investment Advisers Act and the Commodity Exchange Act.

Section 205(a)(1) of the Advisers Act prohibits arrangements for contingent compensation to investment advisers based on profit-sharing arrangements with clients that encourage advisers to take undue risks with client funds. Section 205(e) gives the SEC flexibility to exempt advisory contracts with institutional clients from the ban on performance fees since these clients can appreciate the risks and are in a position to protect themselves from overreaching by the adviser. The SEC makes an exemptive determination based on a number of factors, including a client’s net worth, financial sophistication, and amount of assets under management. The legislation amends Section 205(e) to provide that, if the SEC uses a dollar amount test, such as net asset threshold, as part of determining if an exemption should be given, the Commission must adjust for the effects of inflation on the test every five years. Any adjustment that is not a multiple of $1000 must be rounded to the nearest multiple of $1000.

The Capito-Paulsen Amendment adds to the list of advisers exempted from Advisers Act registration any investment adviser who solely advises small business investment companies licensed under the Small Business Investment Act of 1958. The Amendment also provides that the SEC must exclude from the definition of venture capital fund any fund whose investment adviser solely advises small business investment companies.

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