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.
How Would the Day-to-Day Operation of My Hedge Fund Management Business Change?
The effect here is two-fold: First, there is the effort and additional expense in creating and updating a set of compliance policies and procedures reflecting the actual business of the hedge fund manager. Second, and perhaps more importantly, operating in a regulated environment often requires something of a cultural shift by a hedge fund manager. There may be some angst accompanying a dawning realization that virtually every aspect of the hedge fund manager’s business will need to follow compliance policies and be documented with a set of required records that generally must be maintained for five years, and that can be difficult to accept. For example, there may be resistance to the notion that most employees (and certainly all portfolio managers) will need to report nearly all of their personal securities transactions to the firm’s compliance officer and perhaps obtain pre-clearance to trade.
Compliance Policies and Procedures
The SEC has proposed separately a new rule that would require all registered advisers to maintain a comprehensive set of compliance policies and to appoint a compliance officer. Even without such a rule, this is currently best practice, since a well-run registered investment adviser business requires 10 to 15 such policies, some responding to specific regulatory requirements and others based on industry best practices. At the same time, there is no reason that a small hedge fund manager with limited personnel should be using “one-size-fits-all” policies and procedures more appropriate to a large organization. Indeed, such a course would be very counterproductive since (along with incorrect disclosure in the brochure or other disclosure documents) it is a failure to follow some aspect of its own internal policies and procedures, even where the action may not have been required by the Advisers Act, that often causes problems for registered advisers during an SEC inspection. Examples of policies and procedures include: Code of Ethics and Insider Trading Policy, Trade Processing and Trading Error Policies, Trade Allocation Policy, Proxy Voting Policy, Client Confidentiality Policy, Disaster Recovery Policy, Brokerage Selection Policy, Anti-Money Laundering Policy and Recordkeeping Policy.
It is uncertain how this may develop for hedge fund managers, and one of the criticisms of the report is that the SEC does not have the resources to oversee adequately several thousand hedge fund managers. Currently, a registered adviser is subject to random SEC inspections, and these usually occur every few years. Typically, a member of the SEC staff goes through a comprehensive checklist relating to required policies and practices over a few days, and if only minor problems are found (as they almost always are), a deficiency letter is issued that must be answered with a response indicating how the problems will be addressed. More serious problems can result in a referral to the SEC’s Division of Enforcement and fines or other sanctions.
The Silver Lining and Conclusions
As many commentators have noted, the report could have been worse from the hedge fund industry’s point of view. Nothing in the report or inherent in being a registered adviser would affect the way a manager runs a particular fund’s portfolio, assuming adequate disclosure of the strategy and relevant risks. Additionally, SEC staff suggested that those funds offered only to so-called “qualified purchasers” (an individual with investments of at least US$5 million, for example) should be allowed to engage in general solicitations of prospective investors.
Furthermore, there is a positive side to being registered for a hedge fund manager. Some large institutional investors insist that all of their investments be with registered investment advisers, and a fund that wishes to target pension funds and other investors governed by the Employee Retirement Income Security Act often must be managed by a so-called qualified professional asset manager, which in turn requires, among other things, that the manager be a registered adviser. Finally, it is often much easier for a registered investment adviser to obtain business liability insurance than it is for an unregistered adviser.
This article summarizes some of the most significant aspects of registration with the SEC. Because the Advisers Act is by far the shortest of the major federal securities laws, many of the requirements imposed on a registered adviser are the products of SEC rules adopted under the general anti-fraud provisions of the Advisers Act, or of SEC or SEC staff positions set out in various SEC releases, so-called “no-action” interpretive letters, and other materials. The specifics of how any registered adviser deals with various regulatory requirements depend (or should depend) very much on the particular circumstances of its business. A hedge fund manager should have detailed discussions with counsel and develop a coherent plan to deal with particular issues should registration become necessary.
Attorney Gregory T. Pusch is an associate in the Corporate Practice Group of Edwards & Angell LLP, a 300-attorney national law firm focusing on financial services, private equity and technology. He can be reached at [email protected]