NEW YORK (HedgeWorld.com)--Debate is under way over the recent recommendation by Securities and Exchange Commission staff to require hedge fund managers to register as investment advisers. In particular, how broadly applicable the requirement will be is an open question.
While most observers expect SEC commissioners to take action on the long-expected proposal, there may be need to compromise. "There seems to be disagreement over whether or not managers should register," said attorney Michael Tannenbaum of Tannenbaum Helpern Syracuse & Hirschtritt LLP, New York. "We'll have to wait and see how that plays out."
Lawyers say one option is to limit compulsory registration to managers that have funds for accredited investors and exclude from the mandate those that meet the higher "qualified purchaser" criterion of section 3(c)(7) of the Investment Company Act. Funds that use this exemption from having to register as an investment company are limited to individuals with at least US$5 million net worth and institutions with at least US$25 million.
These are sometimes referred to as the "super-sophisticated" group. By contrast, the current standard for accredited individuals in section 3(c)(1) funds is US$1 million. Many hedge fund managers run funds in both these categories.
Raising the Bar
David Scherl, managing partner of Morrison Cohen Singer & Weinstein LLP, New York, identified three underlying goals in the SEC staff report--to get all or most hedge funds on the SEC radar screen; to standardize reporting and disclosure requirements so that investors can more easily compare hedge funds; and to increase the financial threshold for investing in hedge funds.
Regulators apparently preferred to tackle the third issue indirectly--by having most of the industry register. RIAs are not allowed to charge an incentive fee unless their clients have at least US$1.5 million net worth or $750,000 invested with the manager. That already sets the bar a little higher than the US$1 million accredited investor standard applied to non-registered investment advisers with 3(c)(1) funds.
As it stands, the registration proposal spreads its net wide, including any manager having more than 14 clients, with a new look-through provision that counts each investor as a client. Until now, each fund counted as a client.
A threshold for total assets under management also is recommended, possibly at US $25 million--managers below that would be exempted. But the definition is open, said Stephen Vine of Akin Gump Strauss Hauer & Feld LLP, New York, speaking at a panel.
At least two commissioners, as well as chairman William Donaldson, would have to approve any revision of current registration rules. It probably will be some time early next year before a final decision emerges. "We are still at a very early stage, and a lot needs to happen before this staff report results in new rules or amendments to the law," said Mr. Scherl.
The commission has five members, including Mr. Donaldson. At least one, Paul Atkins, reportedly has doubts about using SEC personnel to shield large investors that should be capable of looking after their own interests. Many pensions require their fund managers to be registered and do not need SEC backing to enforce that. Moreover, institutions such as the giant California Public Employees' Retirement System, Sacramento, are well equipped with professional staffs and high-level outside consultants.
It is likely that Mr. Donaldson will seek a broad consensus, said Mr. Vine. He asked, "Will there be some retreat from universal registration?" A compromise used by the Commodity Futures Trading Commission in the past might serve as model, he said: Impose universal registration but exempt from day-to-day compliance advisers who exclusively deal with highly sophisticated big investors such as pensions.
That could provide a middle ground for SEC commissioners. In addition, it has the practical benefit of reducing the number of managers the regulator will have to supervise. While it has been adding staff, how the SEC will manage to inspect 6,000 hedge funds remains an issue. "The dilemma is how to have an effective inspection program," said Mr. Vine.
He predicts that if compulsive registration is instituted, outsourcing services will develop to deal with the extra work. "If the SEC follows through, this will have an impact on the industry but may have less of an effect on how hedge funds go about their business," he said.
"The compromise position would be to cause registration for funds that rely on section 3 (c)(1) as opposed to 3 (c)(7)," said Mr. Tannenbaum. If registration is limited to funds that don't meet a certain financial test, the one criterion being mentioned a lot is the qualified investor test.
A separate proposal in the SEC report also makes this distinction. It suggests easing the prohibition against public solicitation or advertising but only for funds based on section 3(c)(7). The reasoning is similar--large and knowledgeable investors need no protection from solicitation.
As Mr. Scherl summed up the staff proposals, on the one hand regulators are recommending some tightening of standards for 3 (c)(1) funds, while on the other hand, they're hinting that they may be willing to allow more flexibility in marketing and advertising of 3 (c)(7) funds. SEC staff appears to think this is an appropriate way to split up the industry, he said.
In the meantime, "Expect vigorous debate from the industry," Mr. Vine said. "Many are opposed to any registration."