By John Brunjes and Genna Garver, Bracewell & Giuliani -- President Obama’s plan to modernize financial regulation and supervision reflects a complex and consequential policy that directly impacts private investment funds and their managers. Most significantly, all managers of hedge funds and other private pools of capital, including private equity and venture capital funds, whose assets under management exceed some "modest threshold," would be required to register with the SEC. Managers also would be required to report information to the SEC on the funds they manage to assess whether they should be further regulated by the Federal Reserve. Obama’s plan would also broaden SEC authority over all SEC-registered-registered investment advisers.
We provide below a summary of how the Obama plan, if approved by Congress, would impact private investment funds and their managers. We also highlight questions that linger in the plan's wake.
Genna GarverSEC Registration of Fund Managers
The lack of specificity behind the "modest threshold" of assets under management that would trigger SEC registration leads the list of head-scratchers in the Obama plan. Obama has yet to suggest a particular number. Under current law, the SEC regulates managers with client assets over $25 million, while regulation of managers with client assets under $25 million is reserved for the states. Depending on the amount of the "modest threshold," managers currently regulated by the SEC may instead become subject to state regulation. Considering recent SEC enforcement fumbles, Obama may have good reason to raise the $25 million threshold to avoid spreading the SEC too thin—a move that would appeal to state securities regulators. The "modest threshold" may take on greater relevance if the so-called "private client exemption" from registration under the Investment Advisers Act is eliminated as discussed below.
Another head-scratcher in the Obama plan is how he intends to rein in those managers who currently slip through the regulatory cracks (once beyond the grasp of state regulators) by the "private client exemption" from registration for advisers with 15 or fewer clients—where the term "clients" is defined in a way that allows each fund to be counted as a single client even where the underlying limited partners may number into the hundreds. Legislators in the current session of Congress have already proposed bills that would eliminate the private client exemption, including H.R. 711, “Hedge Fund Advisers Registration Act of 2009,” proposed by Representatives Michael Castle (R-DE) and Michael Capuano (D-MA), and S.1278, “Private Fund Transparency Act of 2009,” proposed by Senator Jack Reed (D-R.I.).
If the private client exemption is eliminated, all fund managers with client assets exceeding Obama's "modest threshold" would be required to register with the SEC (absent the availability of another exemption). Fund managers with client assets under Obama's "modest threshold" would likely fall under the supervisory authority of their home state, but not necessarily safe from registration—state legislatures, like Connecticut, are also considering closing the regulatory cracks for investment advisers and may follow suit. Ultimately, registration of fund managers with either the SEC or their home state securities regulator seems imminent.
As SEC-registered investment advisers, fund managers would be subject to the Investment Advisers Act of 1940 and its bevy of regulations, including significant recordkeeping requirements, compliance procedures, reporting requirements, advertising restrictions, and prohibitions on certain transactions. In addition, the Obama plan proposes to subject all funds advised by SEC-registered advisers to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; regulatory reporting requirements, and SEC examinations to monitor compliance with these requirements. The regulatory reporting requirements for such funds would require reporting on a confidential basis of 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 requires greater regulation for financial stability purposes.
John BrunjesPossible Supervision and Regulation of Funds by Federal Reserve as a Tier 1 FHC
The Obama plan would authorize the SEC to share with the Federal Reserve the confidential reports of funds advised by SEC-registered investment advisers. The Federal Reserve would determine whether any of those funds or fund families requires greater regulation for financial stability purposes (the Obama plan refers to those funds as “Tier 1 Financial Holdings Companies” or “Tier 1 FHCs”). The Federal Reserve would also have authority to examine any of those funds if the Federal Reserve is unable to determine whether the fund’s financial activities pose a threat to financial stability based on regulatory reports, discussions with management, and publicly available information. Toward that end, the Obama administration will propose legislation setting forth criteria that the Federal Reserve should consider in identifying Tier 1 FHCs, which as presently envisioned would include the following factors:
- the impact the firm’s failure would have on the financial system and economy;
- the firm’s combination of size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding; and
- the firm’s criticality as a source of credit for households, businesses, and state and local governments and as a source of liquidity for the financial system.
In addition, the Federal Reserve would be allowed to consider other relevant factors and exercise discretion in applying the specified factors to individual financial firms.
Once identified as a Tier 1 FHC, a fund would be subject to heightened supervision and regulation by the Federal Reserve. At a minimum, Tier 1 FHCs would be required to meet the qualification requirements for "financial holding companies" set forth in the Bank Holding Company Act of 1956 and its regulations, including being well capitalized and well managed. However, the prudential standards for Tier 1 FHCs — including capital, liquidity and risk management standards — would be stricter and more conservative than those applicable to other financial firms to account for the greater risks that their potential failure would impose on the financial system. How much stricter and more conservative has yet to be revealed.
As if the obvious terminology weren't a sufficient hint, funds identified as Tier 1 FHCs would be subject to regulation and supervision currently reserved for depository institutions and their holding companies. Obama's message is clear: the presence of large, unregistered funds in the U.S. "shadow banking system" must come to a swift end.
The question lingering is how the framework established for banks and bank holding companies, including the prudential capital, liquidity and management standards, would be applied to private investment funds. Such concepts as maintaining risk-based capital and leverage ratios and restricting nonfinancial activities cannot be directly applied to a fund, at least not without further regulatory clarification. In fact, the concept of maintaining capital is in part contrary to the investment business of most funds. Unlike bank depositors, fund investors commit capital with the objective of capital appreciation, not preservation for liquidity. In addition, the legal form of most funds is a limited partnership, not a stock-based bank charter, rendering the current capital adequacy guidelines almost nonsensical in their application to funds. Although Gramm-Leach-Bliely permits financial holding companies to conduct all financial and many nonfinancial activities, the Glass-Steagall wall between the banking and commerce remains, at least in part.
The restrictions on nonfinancial activities (except insofar as found incidental or complementary to financial activities) would prohibit many controlling investments traditionally made by private equity and venture capital funds.
Greater SEC Regulation of All Investment Advisers
Even SEC-registered investment advisers who provide advice solely on a managed account basis face greater regulation. The Obama administration will propose legislation to empower the SEC to bolster protections for all clients of SEC-registered investment advisers by:
- Requiring simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment advisers;
- Prohibiting certain conflicts of interest and sales practices that are contrary to the interests of investors — the SEC would be empowered to examine and ban forms of compensation that encourage investment advisers to put investors into products that are profitable to the adviser, but are not in the investors’ best interest; and
- Prohibiting mandatory arbitration clauses in investor contracts (after the SEC conducts a study on whether investors are harmed by being unable to obtain effective redress of legitimate grievances, as well as whether changes to arbitration are appropriate).
Although the Obama plan leaves many questions unanswered, greater regulation and supervision is imminent and fund managers should not assume the luxury of significantly delayed effective dates. However, fund managers should be cautioned not to run to register in advance without understanding its implications, or to adopt policies and procedures not specifically tailored to your business or risks. Instead, while Congress reviews the Obama plan, fund managers should review their business—identify conflicts of interest, business practices, arrangements, and other factors creating risk for the fund manager and its clients in relation to its operations. Then fund managers should review or develop, as the case may be, policies and procedures that specifically address those factors and the controls to be implemented to supervise and mitigate those areas of concern.
John Brunjes and Genna Garver are in the Private Investment Funds Group of Bracewell & Giuliani, LLP, representing hedge funds, private equity funds and venture capitalists in connection with fund formation and operations issues and illiquid investment transactions, with particular emphasis on advising private domestic and offshore capital pools and their stakeholders. John is head of the Fund Formation practice and a member of the Board of Directors of the Connecticut Hedge Fund Association.
What Obama’s Regulatory “Overhaul” Means for Private Funds
HedgeOp: How Obama's Proposals May Affect Hedge Funds
SEC Commish Calls For Broader Hedge Fund Regs
Hedge Funds Get Off Easy In Regulatory Overhaul, For Now
Hedge Fund Group Warns Against Blanket Regulations