What Obama’s Regulatory “Overhaul” Means for Private Funds

Jun 20 2009 | 3:19pm ET

By Lawrence Cohen -- On June 17, 2009, the Obama administration published its proposal for what it described as a “sweeping overhaul of the financial regulatory system.”  The official Department of the Treasury document is titled “A New Foundation: Rebuilding Financial Supervision and Regulation” (the “Proposal”).

No member of the fund industry realistically expects that the Proposal will be implemented line-by-line.  Commentators have already strongly criticized its approach and the plan will be subject to intense debate in Congress. 

Also, there is a great deal of ambiguity in the text that provides wide berth for adjustments.  Although the Proposal has no authority to compel the passage of laws or regulations - it is essentially a set of talking points - it will undoubtedly promote enhanced regulation that will impact the operations of most, if not all, private funds.

The Proposal offers suggestions for:  clear accountability in financial oversight and supervision; establishing comprehensive supervision of financial markets; protecting consumers and investors from financial abuse by promoting transparency, simplicity, fairness, accountability, and access; providing the government with tools to manage financial crises; and raising international regulatory standards and improving cooperation.

Widespread concern about abuses in the private fund industry was certain to trigger specific recommendations by the Treasury Department.  Under the Proposal’s category of supervision and regulation, the administration suggests that advisers of hedge funds and other private pools of capital be registered with the SEC.  Pointing out that “investment banks operated with insufficient government oversight” and “hedge funds and other private pools of capital operated completely outside of the supervisory framework,” the Proposal states that:

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act. The advisers should be required to report information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability.

According to the Proposal, registration would facilitate the collection of data that would “permit an informed assessment of how such funds are changing over time and whether any such funds have become so large, leveraged, or interconnected that they require regulation for financial stability purposes.”

Regulation would extend not only to the managers of funds, but all funds advised by an SEC-registered investment adviser would be subject to “recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements.”  The Proposal does recognize that regulatory requirements may vary according to the type of private pool.  Regular, periodic SEC audits of such funds are called for, to monitor compliance with these requirements. 

The Proposal seeks reporting requirements on a confidential basis for funds managed by SEC advisers covering “the amount of assets under management, borrowings, off-balance sheet exposures, and other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that it poses a threat to financial stability.”  These reports would be shared with the Federal Reserve, which would determine whether any of the funds or fund families meets the Tier 1 Financial Holding Company (FHC) criteria -- “If so, those funds should be supervised and regulated as Tier 1 FHCs.”

For decades, many parties have called for the merger of the SEC and CFTC for more efficient regulation of both the securities and futures markets (particularly since there are many derivative and “hybrid” products that arguably fall under the purview of both agencies).  The Treasury Department did not pursue that objective, choosing to address the less jarring “harmonization” of the securities and futures markets.  The Proposal does call for the elimination of” jurisdictional uncertainties” and suggests that “economically equivalent instruments” should be regulated in the same manner, “regardless of which agency has jurisdiction.”  In measured language, the Proposal notes the importance of the CFTC’s maintenance of its “enforcement authority over these entities as the SEC takes on important new responsibilities in this area.”  While not calling aggressively for a combined agency, the Proposal did suggest that the CFTC and the SEC report to Congress by September 30, 2009 on their relative approaches, with recommendations to synchronize the regulation of the securities and futures products.  The Proposal provides that, if the agencies cannot reach agreement on such explanations and recommendations, “their differences should be referred to the new Financial Services Oversight Council [chaired by Treasury and including the heads of the principal federal financial regulators], which should address the differences and make recommendations to Congress “within six months of its formation.”

The strengthening of capital and other “prudential standards” is recognized as an important element of the overhaul of our regulatory system.  In connection with this goal, and to protect the “federal safety net” supporting our nation’s banks, the Proposal seeks to reinforce the firewalls between banks and their affiliates.  It is specifically recommended that the Federal Reserve and the federal banking agencies increase their supervision and regulation of potential conflicts of interest inherent in banks and hedge funds that are affiliated.

In the Proposal’s suggestions to press for higher international regulatory standards and improve international cooperation, it recommends the expansion of the G-20 commitment to have national authorities, by the end of 2009, require hedge funds or their managers to register and disclose appropriate information required to assess the systemic risk they generate.  The Proposal seeks to apply this to advisers of other pools of capital and recommends that recordkeeping and additional disclosure requirements be imposed on investors, creditors and counterparties.

Other areas in the Proposal that impact the operations of private funds range from suggesting the development of more stringent tax policies, with the strengthening of global standards and reduction of “geographic regulatory gaps,” and the enhancement of anti-money laundering practices.

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.


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