On July 28, 2004, the Securities and Exchange Commission published for comment in Release No. IA-2266 rules to require hedge fund advisers to register with the SEC under the Investment Advisers Act of 1940. The release cited three general areas as the basis for the proposed rule: (1) the growth of the hedge fund industry, (2) the incidence of fraud in the industry and (3) the “retailization” of the industry. The proposed rule was approved by a 3 to 2 vote that reflected a sharply divided commission.
Upon the close of the comment period on Sept. 15, 2004, the SEC had received 175 comment letters from various industry participants including hedge fund advisers, attorneys, industry and regulatory organizations and investors (see Previous HedgeWorld Story). An overwhelming majority of the respondents were opposed to the proposal and were of the view that the facts underlying the three stated areas of concern do not support adoption of the mandatory registration proposal. In addition, they believe that direct regulation would entail significant costs and unintended consequences for the industry, investors, and U.S. capital markets. Some commentators noted that significant information about the hedge fund industry already is available to regulatory agencies that directly or indirectly oversee hedge fund activities and that the coordination and sharing of such information would serve to achieve the SEC’s objectives without great cost to the hedge fund industry and our capital markets.
Respondents that favored the commission’s proposal say it is a measured and appropriate response to address the risks that hedge funds pose to the securities markets and participants in those markets. They say registration will strengthen the industry by mandating higher standards for all advisers that would, in effect, cause them to tighten their procedures toward a greater “culture of compliance” to the ultimate benefit of investors. Still others commented that the SEC should take more time to understand the data already available to it and to other federal regulators with a view toward devising a more narrowly tailored response to whatever problems may eventually be identified. They believe that an approach based on additional information would result in better public policy.
Growth of Hedge Fund Industry
Although hedge funds represent a relatively small portion of the financial markets, they are growing at a substantial rate and are projected to have assets under management of approximately US$1 trillion by the end of 2004. Despite this growth, the commission does not have meaningful information regarding the number of hedge funds currently operating, the investments that they hold or who controls them.
Some commentators supported the commission’s goal of providing a mechanism to obtain basic and meaningful information about hedge funds and of providing hedge fund investors with the kind of important investor protections that clients of registered investment advisers enjoy. However, they do not believe it is necessary to require hedge funds to register under the Advisers Act in order to achieve these goals. There are other outlets that can be explored to provide the commission with the necessary information that it believes it needs to better understand the industry.
Incidence of Fraud
The commission has expressed concern that the growth in hedge funds has been accompanied by growth in the number of hedge fund enforcement actions. Commentators, however, pointed out that the record does not show disproportionately high instances of fraud in the industry, suggesting that market discipline imposed by hedge funds’ sophisticated investor base is currently adequate. The SEC Staff Report, Implications of the Growth of Hedge Funds (September 2003), notes that there is “no evidence indicating that hedge funds or their advisers engage disproportionately in fraudulent activity”. In the release, the SEC indicates that its concern with fraud by hedge funds stems in part from the mutual fund late trading and market timing that has been uncovered and, in part, from an increase in the number of enforcement cases brought by the SEC with respect to hedge funds. However, as two SEC commissioners pointed out in their dissent, the new regulatory regime proposed by the SEC would not address the types of frauds observed in market timing and late trading. Many of the instances of fraud cited in the release involve small funds that would be exempted from mandatory registration, funds that already were registered under current regulations and funds that deliberately evaded registration. Moreover, the number of enforcement cases brought by the SEC against hedge funds in the last five years remains relatively small, less than 2% of the total cases. There appears to be substantial doubt that the proposed mandatory registration rule in fact would increase the commission’s ability to detect and address fraud.
As a result of registration, the commission will have, for the first time, the ability to inspect all hedge funds. Those in support of the regulations point out that this will enable the commission to proactively address, not reactively respond to, potentially fraudulent activities in the hedge fund arena.
The release cites “retailization” of hedge funds, referring to the direct or indirect exposure of smaller investors to hedge funds, as a concern. This has been brought on by the increase in the number of “funds of hedge funds,” which normally require lower minimum investments, and increased participation in hedge funds by a growing number of private and public pension plans, universities, endowments, foundations and other charitable organizations.
Some commentators noted that if retail investors are inappropriately participating directly in hedge funds that are not registered as investment companies, the SEC has authority to make changes to the definition of “accredited investor.” To the extent retail investors are participating through registered funds of funds, the SEC has full authority over those registered investment companies. Pension funds are overseen by the Department of Labor.
A majority of commentators did not believe that mandatory registration of hedge fund advisers is necessary to address the possible retailization of hedge fund investors. Hedge fund advisers generally are exempt from registration under the Advisers Act only if, among other things, the funds they advise qualify for exemption under either section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, which by definition generally limits direct investment in those funds to institutions and other sophisticated investors. Hedge fund investors are not within the category of so-called “retail” investors whose protection historically has been a principal touchstone of federal securities law. If inflation has caused some retail investors to now qualify as accredited investors, the Commission has full power and authority to increase those dollar thresholds at any time.
Many commentators expressed concern that the proposal, if adopted, could have unintended adverse consequences for U.S. securities markets. Hedge funds are an important source of liquidity to the marketplace. They are able to supply liquidity not just because of their size but also because of their ability to use leverage and to engage in a myriad of trading strategies. Some commentators were concerned that registration could lead to changes in hedge fund behavior, depriving marketplaces of needed liquidity. These commentators further assert that the burdens associated with mandatory registration could stifle innovation and deter money managers from entering the industry. They state that the imposition of such a regulatory scheme could impair the development of innovative and adaptive investment strategies that have contributed to the success of the hedge fund industry and may cause advisers to manage their businesses to meet SEC expectations rather than to develop strategies that contribute to market efficiency.
The adoption of the mandatory registration proposal, which is viewed as a “modest first step,” could have adverse effects on U.S. capital markets by deterring financial innovation and reducing liquidity. Future additional, but as yet undefined regulation, could adversely affect capital markets.
The vast majority of hedge funds are small and would have difficulty absorbing the additional expenses of complying with the registration requirements. Many hedge funds do not have the financial resources to hire separate compliance officers, develop and document formal compliance policies and procedures or to build the formal infrastructure required to meet the requirements of the Advisers Act.
Comments on Specific Topics
Rule 206(4)-2 of the Advisers Act (the custody rule) specifies that registered investment advisers be deemed to have custody of the assets of the investors in their hedge funds unless the assets are held by qualified custodians and are subject to certain additional requirements. The custody rule specifies that the additional requirements may be met if a hedge fund or fund of funds is audited annually and the audited statements are sent to investors in the fund within 120 days after the fund’s fiscal year end.
The SEC’s proposed amendment would permit registered investment advisers to satisfy the custody rule by extending from 120 days to 180 days the period by which hedge fund audited financial statements must be sent to investors. The amendment, as currently proposed, would apply to all RIAs, not just to those advising non-registered funds. Commentators strongly supported the SEC proposal to extend this period to 180 days for fund of funds advisers only and to keep the current 120-day requirement for non-fund of funds advisers. The additional 60 days would provide funds of funds time to complete their own audits once the financial statements of the underlying funds are received. Some hedge fund advisers further suggested that a fund of funds be defined for purposes of the custody rule and that a standard be established based on a threshold percentage by which a hedge fund is invested in other hedge funds.
Current rules provide that a hedge fund adviser may count any hedge fund it manages as a single client for purposes of the 15-client limit test. The commission proposes to amend this threshold with Rule 203(b)(3)-2(a), which will require that hedge fund advisers count each shareholder, limited partner, member, other security holder or beneficiary of a private fund as a client.
In making this determination, advisors would be required to “look through” investee hedge funds to their underlying shareholders, members, etc., for purposes of this test. This change would make it difficult to qualify under the 15-client limit as registration could be triggered by circumstances that are outside of the adviser’s control, or more important, outside his or her knowledge. Commentators proposed that looking through to an underlying hedge funds’ investors should only be applicable if the underlying hedge fund makes up more than 10% of the fund’s capital, is not affiliated with the adviser and is not formed specifically for the purpose of investing with the adviser. Second, many hedge fund advisers manage funds for family members, affiliates and employees. Commentators believed that such persons should not be counted as clients of the adviser.
Grandfathering Qualified Clients
Most hedge fund advisers charge a performance fee based on a percentage of their funds’ net profits. Rule 205-3 of the Advisers Act permits registered investment advisers to charge performance fees only to qualified clients. The proposed amendment to Rule 205-3 would allow current investors who do not meet the qualified client requirements to remain as investors in a hedge fund. Most commentators approved of the proposed amendment as it would enable such investors to continue to invest in hedge funds. However, commentators sought clarification on whether additional investments made by these investors could be subject to a performance fee.
Private Fund Definition
Advisers managing funds with less than US$25 million of assets and which allow redemptions within two years would not be subject to the “look-through” rule. Advisers of most private equity and venture capital funds thus would continue to be exempt from registration.
One industry group representing private and institutional investors in hedge funds noted that a “redeemability” definition is likely to cause hedge fund advisers to lengthen their redemption periods. Other commentators suggested that the rule apply a test that focuses on the liquidity of a fund’s holdings, rather than on an investor’s willingness to lock up their investment. They suggested that the SEC create an exemption for private equity and venture capital funds based on the nature of their portfolios, which generally are illiquid, and on their redemption restrictions or ongoing subscription provisions after the initial offering period.
Other commentators requested that the commission provide additional guidance on whether events that cause investors to redeem a portion of their investment would constitute a redemption. Such events could include unforeseen and extraordinary circumstances like death or disability.
Some commentators recommended that the commission provide an exemption from registration for non-U.S. advisers who are subject to regulation by non-U.S. regulatory agencies. They pointed out that the majority of advisers located outside the United States already are required to comply with requirements in their home jurisdictions. Regulatory agencies, such as the Financial Services Authority, provide significant oversight of hedge fund advisers under their jurisdiction. They further suggested that advisers located outside the United States should not be required to register unless the total capital of their U.S. investors makes up more than 25% of their total assets under management.
Other Regulatory Agencies
Commentators have suggested that if the SEC requires registration of hedge fund advisers, it should defer to other regulators that oversee components of the hedge fund industry. For example, hedge fund advisers that are registered with the CFTC as commodity trading advisers or commodity pool operators should be exempted. Requiring CFTC regulated entities to register with the SEC could subject them to duplicative and conflicting regulatory oversight.
Some commentators assert that the Advisers Act’s exclusion from registration for hedge fund advisers that have fewer than 15 clients was never meant to count each of the investors in a fund as a single client (although the SEC generally has the authority to implement through regulation laws passed by Congress, including the Advisers Act). Commentators suggested that enacting a proposal that redefines prior interpretations of the Advisers Act would be inconsistent with Congressional intent.
While a number of commentators were strongly opposed to the proposed mandatory registration rule, many did not object in principle to the commission collecting and evaluating a broader range of information about hedge funds and their advisers.
Many commentators pointed out that there are mechanisms available to the SEC to obtain this information without requiring hedge fund advisers to register. The SEC could condition the availability of the current private investor exemption to advisers filing basic information about their funds with the SEC (i.e., form ADV), making specified disclosures to investors and requiring compliance with certain investor protection requirements applicable to registered investment advisers, such as the following:
1.Minimum investor qualifications at or above current accredited investor levels;
2.Maximum threshold of assets under management (to be established by the SEC);
3.Custody of private investment fund assets in an identified broker-dealer or bank;
4.Annual audit and delivery of financial statements to investors;
5.Quarterly unaudited financial reports to investors;
6.Clear disclosure of financial arrangements with interested parties;
7.Adoption of written supervisory and compliance policies and procedures and code of ethics; and
8.Clear, objective and transparent valuation standards.
Regardless of whether the SEC votes to approve the release, it is clear that hedge funds are continuing to register on the government’s radar because of their significant growth patterns in recent years.
Stuart Cohen is a principal in Ernst & Young’s Global Hedge Fund Practice based in New York. George Saffayeh is a senior manager in Ernst & Young’s Global Hedge Fund Practice and also is based in New York.
Contact Bob Keane with questions or comments at: [email protected].