The regulatory landscape for fund managers—both in the United States and in Europe—is likely to see some big changes in the coming months and years. John Brunjes, a partner in the private investment funds practice at law firm Bracewell & Giuliani, recently answered some questions from FINalternatives' Jonathan Shazar about what we can expect to see coming out of Washington; the effect the new laws may have on fund managers; and what he thinks of Millennium Management's move to create a regulatory and compliance board.
What do you expect to come out of the House-Senate conference on the financial reform bill as regards the alternative investments industry? Will the Volcker rule provisions survive?
Clearly, registration of hedge fund and private equity fund managers under the Advisers Act is a virtual certainty. In a similar vein, an increase in the "NSMIA threshold" from the current $25 million to $100 million or more also seems very likely. This should have the effect of increasing the number of these fund managers subject to oversight by securities regulators in their home states, rather than by the Commission. Transparency concerning derivatives trading also seems highly likely. Both bills have Volckeresque provisions so it would seem that some of those directives will make it into a final bill.
The differences now are that the House bill delegates to the pertinent regulators the authority to define which activities to proscribe, rather than flatly prohibiting any activities by statute. Under the Senate bill, the council has to conduct an inquiry and make recommendations within six months following the enactment of the law, and then the banking agencies have nine more months to act on those recommendations. At the end of the day, similar to the House bill this would result in a rule-making exercise at the agency level. The extent to which the congressional intent as expressed in the final law is potentially lost in translation or even exceeded by the implementing agencies will be another source of controversy.
When we spoke in February about the Connecticut hedge fund registration proposal, you noted that its adoption could lead to managers quitting Fairfield County for Westchester or New York City. Do the differences between the EU approach and the U.S. approach to regulation offer any similar opportunities for regulatory arbitrage? Or will it hurt both jurisdictions?
As long as there are perceived discrepancies or advantages as between jurisdictions on their regulatory schemes, managers will seek to exploit those if they feel it provides a meaningful competitive advantage. Even if the U.S. were perceived as a more lenient jurisdiction for the domicile of managers, the EU is moving toward a uniform capital access model with the continuing refinements of the UCITS vehicle. When all is said and done, the jurisdictions that strike the balance between investor protection (which is generally manifest through the imposition of various operating conditions on managers) and ease of access to a robust investor base will rule the day. Within the United States, the same principle applies to regulation at the State level.
What will be the impact of the carried-interest tax legislation, should it become law? Will it affect hedge funds and private equity firms differently?
The carried interest tax legislation will impact individuals who manage private equity, venture capital and real estate funds far more dramatically because, in contrast to hedge funds, their distributions tend to result from extended duration realization events that receive long-term capital gains treatment. The level of portfolio turnover in most actively managed hedge funds means that most compensation, including annual performance-based compensation, is treated as short-term gains taxed at ordinary income rates.
Whether or not it impacts the private equity community more so than the hedge fund community, it reveals a lack of appreciation for the value of these investment vehicles as engines of economic growth and disregards one of the basic underpinnings in U.S. tax policy of imposing tax based on the economic substance and effect of transactions, rather than singling out particular participants in those transactions or within a particular industry who engage in those transactions.
German Chancellor Angela Merkel indicated recently that the EU hedge fund directive is only a start. What direction will new regulation take, in the EU, U.S. and internationally?
The common threads seem to be increased disclosure and transparency in numerous forms, applicable to management entities and principals as well as the vehicles they manage and the underlying investing activities they engage in, and with whom.
What do you make of Millennium Management's move to create a regulatory and compliance board? Will it be important for other hedge funds to follow suit? Will it be important for them to match Millennium's firepower (Freeh, Pitt, Sporkin, etc.)? (See related article: Ex-FBI, SEC Chiefs To Advise Millennium)
Both large and small funds have utilized non-binding "advisory panels" for years as a means of providing additional comfort to investors with regard to certain decisions by the fund manager. Sometimes the panel members are relied upon for their professional expertise in substantive areas within the overall investment strategy. Other times they serve more of a "check and balance" function for the protection of the fund's investors by reviewing proposed investment decisions that may give rise to thorny conflicts of interest concerns as between the fund manager, its affiliates, and one or more of the funds that it manages.
An advisory panel focused on regulatory and compliance certainly suggests the growing importance of this area as a type of operational risk. Its also signals a recognition by at least some fund managers that significant regulatory and legislative initiatives are likely to be adopted, and that the parade of potentially landscape-altering proposals both internationally and from Congress and the federal agencies may continue for some time. When coupled with the stepped-up SEC and DOJ scrutiny of private investment funds, an advisory panel composed of highly-visible former government officials of the caliber Millennium has enlisted certainly has a "bring it on" air about it. As an aside, there are liability risks associated with these panels that need to be carefully considered by the managers creating them and the members being asked to serve on them.