By Lawrence Cohen -- As regulatory responses to the global economic crisis develop, managers of hedge funds, private equity funds and venture capital funds are bracing for new and comprehensive regulations. While many proposed laws and rules have not yet been finalized, government agencies, legislators and investors around the world are in the process of formulating and debating proposals that will almost certainly result in far stricter conditions for the operation of hedge funds and other private investment vehicles than are presently imposed
Senate Bill S. 344, “The Hedge Fund Transparency Act,” introduced by Senators Charles Grassley (R-IA) and Carl Levin (D-MI) on Jan. 29 seeks to require hedge funds to register with the Securities and Exchange Commission. According to Senator Grassley, this proposed legislation “removes the loophole previously used by hedge funds to escape the definition of an ‘investment company’ under the [Investment Company Act].” It applies not only to what are commonly referred to as hedge funds, but to all private investment companies, including private equity funds and venture capital funds, with assets of $50,000,000 or more. It was referred to the Senate Committee on Banking, Housing, and Urban Affairs, where it awaits further action.
On April 27, at the Reuters Global Financial Regulation Summit, Senator Grassley pointed out that the Transparency Act was designed to overturn the April 2006 D.C. Court of Appeals Goldstein decision. That decision vacated the SEC’s 2004 amendments to Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (“Advisers Act”) which required hedge fund managers to register as investment advisers. As reported by Reuters, Grassley stated, "Maybe some of the information that came from registration [of managers] would bring about some enforcement of existing law at that particular time.”
Also speaking at the Reuters Global Financial Regulation Summit was SEC Chairman Mary Schapiro, who said that registration alone "would not be sufficient" unless the SEC also had “the ability to inspect and examine, . . . to require the maintenance of books and records and some further rulemaking authority." Schapiro stated that she has discussed the issue of hedge fund regulation with U.S. Treasury Secretary Timothy Geithner, mentioning that Geithner supports requiring managers of “big” hedge funds, private equity funds and venture capital funds to register with the SEC. According to Reuters, Geithner also wants funds to “disclose their counterparties and information needed to assess whether a fund is so large or highly leveraged that it poses a threat to U.S. financial stability,” but Schapiro has not yet expressed her position on counterparty disclosure.
Also advocating for registration of private fund managers is Andrew J. Donohue, Director of the SEC's Division of Investment Management. Speaking on a panel at the Mutual Fund Directors Forum on May 4, he stated that the Advisers Act exemption from registration for advisers with fewer than 15 clients in a year, typically relied upon by private fund managers on the basis that each fund is a considered to be a "client," is a "gap that probably should be closed."
International pressure is also increasing to reform the regulation of the world’s financial markets. Prior to the April 2 Group of 20 Summit, European leaders jointly called for enhanced hedge fund regulation. On April 29, the European Commission proposed a draft law that would introduce mandatory registration of hedge fund managers and oblige private equity firms to disclose data to regulators. According to Reuters, the draft law covers also covers other so-called alternative investment funds managers.
The draft law applies to hedge fund managers based in the European Union that run portfolios worth more than 100 million euros. It proposes that in order to operate in the EU, a manager must be authorized and subject to ongoing supervision and they must ensure that key service providers (i.e., depositaries and third-party administrators) are subject to rigorous regulations. Non-EU domiciled funds can be sold across the EU three years after the law takes effect, subject to meeting stringent regulatory standards. The draft law will not preempt existing national rules (e.g., British rules that allow non-EU hedge funds to be marketed locally). With respect to private equity funds, the draft law imposes disclosure requirements upon private equity groups with assets over 500 million euros and mandates that firms disclose details about their performance to stakeholders. As expected, the draft law has been met with substantial criticism from industry representatives.
Be Prepared - Best Practices
While it is anticipated that the hedge fund industry will mount significant pressure to defeat or modify proposed regulations in any jurisdiction, it is prudent for private investment companies to prepare for potential registration with and disclosure of information to the SEC and foreign regulatory agencies that have (or will be granted) oversight over their activities. Not only are registration and stronger disclosure requirements in the regulatory pipeline, but hedge funds and other private investment companies can expect to be subject to obligations under anti-money laundering measures.
Accordingly, private investment companies with either exclusively domestic U.S. investors or structures calling for overseas distribution are advised to consider undertaking sufficient compliance measures modeled after those of registered investment companies and advisers under a “best practices” approach. While the ultimate requirements of the proposed laws and regulations discussed above cannot be predicted with absolute certainty, in our experience companies that acknowledge the likely institution of regulations and launch the appropriate internal policies and procedures in a timely manner will have a much less difficult transition when final rules become effective.
To be clear, we are not suggesting that a company register with the SEC or other regulator if such a requirement is not necessary. We are pointing out that companies should be prepared for the prospect of registration and government oversight by reviewing and, where appropriate, enhancing their management systems (including making appropriate organizational changes to the number and the nature of the responsibilities of its officers and staff) and written compliance procedures (if there are none, such a document should be prepared and distributed to all personnel).
The books and records of the fund and its manager should be reviewed to ensure that they conform to the standards of the SEC or other applicable jurisdiction. With respect to anti-money laundering, it is doubtful that these measures will be overlooked by either U.S. or non-U.S., regulators, likely requiring policies and procedures for the private fund industry. Each company’s technology should be examined for the capability to make electronic filings of documents and reports and to ensure that its databases which may be subject to inspection are in a searchable format. To make sure that all systems and procedures are carried out properly, hedge funds and other private investment companies should institute periodic comprehensive training programs for their employees.
Based on pronouncements by the Obama administration, members of Congress, foreign leaders and international organizations, it would be surprising if new and significant regulatory measures for hedge funds and other private investment funds are not imposed over the next year. Being prepared for the prospect, or inevitability, of such new laws and regulations may result in future success in very difficult economic times.
Lawrence Cohen is a director in the corporate department at law firm Gibbons P.C. As a former legal officer and compliance director of mutual fund groups, he brings practical experience to the regulation and registration of public investment companies and the formation and operation of private investment companies.