On Sept. 29, following a review of the hedge fund industry over the past year or so, the Securities and Exchange Commission released a report by the SEC staff, the Implications of the Growth of Hedge Funds. The report proposes that virtually all hedge fund managers be required to register with the SEC. Recent publicity about hedge fund trading of mutual fund shares and the general impetus toward greater regulatory oversight in the current environment lead many observers to conclude that the recommendation likely will be adopted relatively soon, though news reports suggest that the two Republican SEC commissioners other than Chairman William Donaldson might resist this step.
This development presents two over-arching business concerns for a currently unregistered hedge fund manager: How would relations with my investors change, and how would the day-to-day operation of my hedge fund management business change?
How Would Relations with My Investors Change?
Essentially all hedge fund managers already are considered investment advisers under the Investment Advisers Act of 1940. The current exemption from registration enjoyed by many managers (based on the number of funds they manage) does not exempt them from the general anti-fraud provisions of the Advisers Act (and other federal securities laws and relevant state law). However, becoming a registered investment adviser brings to bear several specific requirements relating to client interaction (including investors in a fund).
Effectively Increases Minimum Investor Qualifications
The interaction of various exemptions under the federal securities laws permitting hedge funds themselves (as opposed to their managers) to be exempt from registration and regulation results in a relatively low minimum wealth or sophistication standard for hedge fund investors. For many funds, an investor must only be an accredited investor–a category including most people having incomes of more than US$200,000 (or joint incomes with a spouse of more than US$300,000), or a net worth above US$1 million. A key impetus behind the staff report’s mandatory registration recommendation is a concern that this limit might be too low. Requiring hedge fund managers to become registered effectively would allow the SEC to raise the minimum wealth qualification since a registered adviser may not charge a performance fee to a hedge fund unless all of the investors are qualified clients having at least US$750,000 invested with that investor or a net worth of US$1.5 million. One implication of this is that hedge fund managers will need to verify that all existing investors in their funds are qualified clients, most likely through the use of an appropriate questionnaire regarding net worth if the minimum investment requirement is not met. A hedge fund manager would need to redeem non-qualified existing investors out of a fund (unless they meet a particular grandfathering provision under the applicable SEC rule).
Requires Specific Disclosures to Investors
In addition to filing a registration statement with the SEC (and relevant states), a registered investment adviser must deliver a brochure describing its policies with respect to various matters–such as allocations of investments, fees, education and background of managers, affiliations and brokerage policies–to each client and provide an annual update. The staff report also recommends that the SEC develop brochure or other disclosure requirements specifically tailored to hedge fund managers. All such brochure disclosure (which is contained in Part II of a registered adviser’s registration statement) soon will be available online to the general public. It is the difference between how a registered adviser describes its business in the brochure and its actual practices that often forms the basis for fraud claims against a registered adviser, so this must be a very carefully drafted document. Other required disclosures to fund investors include descriptions of the adviser’s proxy voting and investor privacy policies.
Requires Possible Changes in Marketing Materials Relating to Prior Performance
The permitted use of prior performance statistics for marketing and other purposes (including use in a fund’s offering documents) is a complicated and nuanced area under the Advisers Act. It is based to a large extent on SEC and SEC staff interpretive materials, rather than clear rules, and is reviewed carefully by SEC staff when inspecting a registered adviser’s business. Depending on the circumstances, it is likely that most hedge fund managers will need to at least modify their practices in this area upon becoming registered.
Formalizes the Use of Placement Agents
Any cash payments by a registered hedge fund manager to a placement agent or “finder” must be made pursuant to a written agreement requiring certain specific disclosures to, and acknowledgements from, investors. The use of non-cash compensation is a more complicated topic that an adviser should discuss with counsel.