Legislation Would Impose Greater Oversight of Hedge Funds and Other Private Funds
In late January, members of Congress introduced two bills that could greatly affect private funds and their managers. Senators Chuck Grassley (R-IA) and Carl Levin (D-MI) proposed “The Hedge Fund Transparency Act of 2009,” which would regulate funds that are currently exempt from most provisions of the Investment Company Act of 1940 (“Investment Company Act”). In the House, Representatives Mike Castle (R-DE) and Mike Capuano (D-MA) introduced “The Hedge Fund Adviser Registration Act of 2009,” which would eliminate the private investment adviser exemption under the Investment Advisers Act of 1940 (“Advisers Act”). Although it is uncertain whether these particular bills will be enacted, their proposals may represent a starting point for greater regulation of private funds. Many members of Congress have expressed concern that there is a lack of governmental oversight over hedge funds, and new regulation of hedge funds and their managers is widely expected to be included in the anticipated overhaul of financial sector regulation. Notably, the scope of both bills would reach beyond hedge funds and their managers to include a wide range of private funds including private equity and venture capital funds and their managers.
The Hedge Fund Transparency Act
The Hedge Fund Transparency Act of 2009 (“HFTA”) would eliminate the exceptions to the definition of “investment company” under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. Currently, funds that have fewer than 100 beneficial owners rely on Section 3(c)(1), and funds that are owned by “qualified purchasers” (as defined under the Investment Company Act) rely on Section 3(c)(7). By being excepted from the definition of “investment company,” such funds are exempted from the Investment Company Act registration requirement and most of the restrictions that apply to registered investment companies such as mutual funds.
The HFTA would transform the Sections 3(c)(1) and 3(c)(7) exceptions into exemptions under new Sections 6(a)(6) and 6(a)(7). Funds relying on the exemptions would still be exempt from most of the provisions of the Investment Company Act, but in order for companies with over $50 million in assets to qualify for the new exemptions, such companies would have to satisfy a host of new conditions. These conditions include:
- registration with the Securities and Exchange Commission;
- maintenance of books and records as required by the SEC;
- cooperation with any SEC request for information or examination; and
- annual filing of information reports with the SEC.
The information required to be filed with the SEC would include:
- the names of the company’s beneficial owners (including limited partner investors);
- an explanation of the ownership structure of the company;
- information on affiliation with other financial institutions;
- the company’s primary accountant and prime broker;
- a statement of the minimum investment commitment required to invest; and
- the current value of the company’s assets.
In addition, the legislation would impose as a requirement for companies with $50 million or more in assets to qualify for the Section 6(a)(6) or 6(a)(7) exemption an obligation to establish an anti-money laundering program and to report suspicious transactions. The HFTA would also empower the SEC to issue guidance and create rules for implementing the legislation. Presumably, such rules would include elaboration of what the registration and books and records requirements would entail, as the legislation as drafted does not specify.
The HFTA raises a number of issues. First, as noted above, it sweeps in all funds who rely on Sections 3(c)(1) and 3(c)(7), not simply hedge funds. While hedge funds have been traditionally cited as a cause for concern, Congress has viewed venture capital and private equity firms with less skepticism. Because of the challenge of defining what a “hedge fund” is, however, it is likely that future regulation of hedge funds will also apply to other types of funds as well.
Second, the HFTA would apply to funds rather than managers. For managers who are registered with the SEC (as would be required under the Hedge Fund Adviser Registration Act, described below) , the HFTA could impose a duplicative regulatory regime with concomitant costs to funds, managers and investors.
Third, the requirement to disclose funds’ beneficial owners is unprecedented under the securities laws. Not even mutual funds, which are subject to extensive regulation under the Investment Company Act, are required to disclose the names of their beneficial owners. Such disclosure could raise privacy concerns and potentially jeopardize the attractiveness of investing in private funds for many investors. It would also make public the investment strategies of funds of funds.
Finally, the drafting of the HFTA creates ambiguities as to whether companies who “register” with the SEC to qualify for the new Sections 6(a)(6) and 6(a)(7) exemptions would become “registered investment companies.” Provisions in various statutes, including the Investment Company Act and the Advisers Act, are drafted to capture “registered investment companies.” For example, the “private adviser exemption” under Section 203(b) of the Advisers Act (discussed below) is not available to an adviser who acts as an adviser to a registered investment company. Although it does not appear that the drafters’ intent is to impose these provisions on heretofore private funds, the legislation would have to be fixed in order to avoid obligating hedge funds and other private funds to comply with these regulations.
The Hedge Fund Adviser Registration Act
The Hedge Fund Adviser Registration Act (“HFARA”) would eliminate the so-called “private adviser exemption” under Section 203(b)(3) of the Advisers Act, which exempts from registration with the SEC any investment adviser who during the course of the preceding 12 months has had fewer than 15 clients and who neither holds itself out to the public as an investment adviser nor acts as an investment adviser to any registered investment company or business development company. Registration with the SEC subjects fund advisers to a range of substantive requirements under the Advisers Act as well as SEC examinations.
Like the HFTA, the HFARA does not distinguish between hedge fund managers and other investment advisers and would thus apply to managers of private equity funds, venture capital funds, real estate funds, etc. The legislation would essentially reverse the D.C. Circuit’s 2006 decision in Goldstein v. SEC to vacate an SEC rule requiring registration of many hedge fund advisers. Since the Goldstein decision, it has been widely expected that at some point Congress would eliminate the private adviser exemption, an expectation that has grown in light of the Obama administration’s and Congress’s stated commitments to overhaul financial sector regulation.
We will continue to monitor developments and issue future reports as appropriate.
|See a copy of the Hedge Fund Transparency Act|
|See a copy of the Hedge Fund Adviser Registration Act|
PWG Committees Finalize Hedge Fund Best Practices Reports
On January 16, 2009, two committees established by the President’s Working Group on Financial Markets (the “PWG”)—the Asset Managers’ Committee and the Investors’ Committee—released final reports on best practices for asset managers and investors in the hedge fund industry. The two reports, which were provisionally released in April 2008 for public comment, aim to reduce systemic risk and foster investor protection by increasing accountability and promoting transparency for hedge fund industry participants.
The Asset Managers’ Committee report calls for the implementation of the following:
- Disclosure. Managers should produce independently audited, GAAP-compliant financial statements similar to those prepared by public companies. In addition, managers should provide investors with performance and risk information at least quarterly.
- Asset Valuation. Managers should maintain documented policies and appropriate controls in order to segregate responsibilities between portfolio managers and valuation personnel. Moreover, managers should establish a governance mechanism such as a valuation committee to monitor compliance with valuation policies. Managers should also go beyond the requirements of GAAP and report to investors—at least quarterly—the percentage of their assets that fall within each level of Financial Accounting Standard 157.
- Risk Management. Managers should identify risks, measure the principal categories of risk (e.g., liquidity risk, leverage, market risk and counterparty credit risk), establish monitoring and measurement criteria, and maintain a regular and rigorous process for monitoring risk. Managers should also carefully assess counterparty creditworthiness and understand the legal relationships they may have with prime brokers, lending or derivative counterparties and their affiliates.
- Business Operations. Managers should establish appropriately segregated functions, processes for documenting counterparty relationships and appropriate infrastructure to accommodate the types of investments traded by the fund. In addition, managers should carefully investigate the qualifications of all service providers such as custodians, prime brokers and administrators.
- Compliance; Conflicts. Managers should adopt a written code of ethics and a written compliance manual which includes a process for handling conflicts of interest, establish robust training programs to educate personnel about policies and maintain a compliance function that includes a Chief Compliance Officer, appropriate discipline and an annual review of the compliance framework. Further, managers should establish a conflicts committee to review and address potential conflicts of interest.
The Investors’ Committee report includes recommendations for individuals tasked with assessing the appropriateness of hedge funds as a component of an investment portfolio and recommendations relating to the execution and administration of hedge fund programs. Among other key points, the Investors' Committee report suggests that investors should use the best practices outlined in the Asset Managers' report as a guideline in conducting due diligence on hedge funds, and stresses the importance of reviewing critical third-party service providers in the due diligence process.
|See a copy of the Asset Managers' Committee Report|
|See a copy of the Investors' Committee Report|
G30 Releases Report Recommending Far Reaching Regulatory Reform in the Financial Industry
On January 15, 2009, the Group of Thirty (“G30”) released a report entitled Financial Reform: A Framework for Financial Stability (“Report”). The committee that authored the Report was chaired by former SEC Chairman Paul A. Volcker, who was recently appointed by President Obama as Chairman of the President’s newly formed Economic Recovery Advisory Board. The Report provides 18 recommendations on how to organize financial systems to better ensure economic stability. While the Report was written to provide recommendations to policymakers in all countries, the Report emphasizes that certain recommendations have a U.S. focus, given the size and global importance of U.S. markets.
The core recommendations in the Report emphasize the need to (i) eliminate gaps and weaknesses in the regulation of systematically significant financial institutions, including hedge funds and private equity funds, (ii) improve national and international policy coordination, (iii) improve regulation in connection with corporate governance, risk management, capital, liquidity and accounting standards and (iv) increase the transparency of financial markets and products, including securitized credit markets and over-the-counter markets. The Report recommends financial reforms that would significantly increase government oversight of the financial system in the U.S. and on an internationally coordinated basis. Some of the significant recommendations affecting the investment management industry are described below.
Money Market Mutual Funds
The Report recommends that money market mutual funds that provide traditional bank services, such as allowing withdrawals on demand, providing traditional transactional account services and assuring investors stable net asset value should be required (i) to register as special purpose banks, (ii) be subject to appropriate regulation and supervision, (iii) obtain governmental insurance and (iv) gain access to central bank lender-of-last-resort facilities. In contrast, money market mutual funds wishing to avoid such regulation should be required to offer only low-risk investment options with modest return potential. They should also be clearly differentiated from federally insured institutions and should offer no implicit or explicit assurances that accounts will maintain a stable net asset value.
The current money market fund model has come into question since the Reserve Primary Fund, a $62 billion money market fund, “broke the buck” in September 2008 following the bankruptcy filing by Lehman Brothers. Many other money market funds experienced liquidity challenges as well in the subsequent weeks, and the Treasury Department instituted a temporary guarantee program for money market fund investors. SEC Division of Investment Management Director Andrew Donohue has stated that consideration of the money market fund model and regulation will be a priority in 2009 (see related article below).
Oversight of Private Pools of Capital
The Report also recommends that private pools of capital, such as hedge funds and private equity funds, should be required to register with an appropriate national regulator, subject to a minimum size threshold and a venture capital exemption. The appropriate national regulator should have authority to require periodic reports and disclosure of information, such as investment strategy, performance and leverage. For private funds that are judged to be systemically significant due to their size, regulators should have the authority to establish standards governing liquidity, capital requirements and risk management. In addition, jurisdiction for the regulation of private funds should be based on the location of the principal place of business of a fund’s manager, and should not be based on the legal domicile of a particular fund. The Report stressed that international coordination on this area is essential to effective regulation given the global nature of the markets in which private funds operate.
As described in the article on recently proposed legislation (above), Congress is currently considering two proposals for increasing regulation of hedge funds and their managers, and some form of increased oversight is widely expected to be enacted. Notably, the Report would except venture capital funds from regulation, while including private equity funds and hedge funds. Since the Treasury Department released its “Blueprint for a Stronger Regulatory Structure” in March 2008, consensus has been building that regulation of some hedge funds that are “systemically significant” will also be part of a financial sector regulatory overhaul.
|See of copy of the G30 report|
SEC Division of Investment Management Focus for 2009
In a January 13, 2009 speech at the Mutual Fund Directors Forum Third Annual Directors’ Institute, Andrew J. Donohue, Director of the SEC’s Division of Investment Management (the “Division”), described the Division’s priorities for 2009. Director Donohue listed the following priorities for the Division in 2009: consideration of the money market fund model, adoption of an exchange traded fund rule, reform of books and records requirements for registered investment advisers, adoption of soft dollar guidance for mutual fund directors, consideration of shareholder report reform and further consideration of Rule 12b-1. Director Donohue devoted much of his speech to discussing (i) the Division’s initiatives and priorities regarding independent directors of mutual funds and (ii) the challenges associated with this year’s annual review of the investment adviser contract.
Director Outreach Initiative
Since 2007, the Investment Management Division has undertaken an initiative, informally known as the “Director Outreach Initiative,” to gain insight into how independent mutual fund directors discharge their duties and to explore ways to improve the current system through SEC rulemaking. As a result of the Director Outreach Initiative, Director Donohue announced that the Division is considering whether to recommend (i) modifications to current regulations that would allow independent directors to delegate certain responsibilities consistent with the valid exercise of their business judgment and (ii) unification of the exemptive rules upon which mutual funds rely to engage in transactions involving conflicts of interest that would otherwise be prohibited under the Investment Company Act of 1940.
Annual Review of the Investment Adviser Contract
The second priority for 2009 that Director Donohue addressed in his speech is the need to improve the annual review process of the investment adviser contract, commonly known as the “15(c) process,” to meet the challenges resulting from the market events of 2008. Director Donohue stressed the importance of this year’s annual review and explained that directors should consider additional issues that have not been present in previous annual reviews, citing two specific examples. First, directors of a mutual fund that has an expense cap and has experienced an increase in its expense ratio (due to a decline in asset values or increased redemptions) should consider whether to modify or eliminate its expense cap. Second, directors of a mutual fund that historically has used a “peer group” as a benchmark to analyze fees charged and expense ratios incurred should consider whether it is still a member of that peer group, or has comparable assets under management, in analyzing fees charged.
|See a copy of Director Donohue’s speech|
SEC’s Richards Discusses Role of Surveillance in Mutual Fund Oversight
In a recent speech at a conference of the Investment Company Institute, Lori Richards, Director of the SEC Office of Compliance Inspections and Examinations (“OCIE”), discussed ways in which SEC oversight of mutual funds may be improved through the use of technology and data analysis. In outlining her views, Director Richards emphasized the importance of sound oversight in light of recent growth in the mutual fund industry and mutual fund portfolio losses.
Richards began by explaining that OCIE currently uses a risk-based oversight model to determine which registered investment adviser to examine based on its assessment of which advisers present the greatest potential for adversely affecting investors. At present, OCIE’s surveillance branch assesses adviser risks based on data contained in Form ADV and information gleaned from compliance control examinations, said Richards. OCIE’s surveillance branch runs a risk-profile algorithm against the investment adviser IARD database on an annual basis to identify advisers with higher risk characteristics. This profile considers a number of factors, including assets under management, number and types of clients, affiliations, other business activities, compensation arrangements, brokerage arrangements and disciplinary history.
Richards suggested that a similar risk assessment methodology could be implemented for mutual funds. A robust surveillance program would be beneficial because it could help identify indications of mispricing, liquidity concerns, lack of diversification and deviations from stated investment objectives, Richards said.
According to Richards, a mutual fund surveillance program would enhance the SEC’s ability to identify risks, firms exhibiting deviant behavior and other problems through, for instance, the use of anomaly detection algorithms. Consequently, the SEC would be better able to focus its resources on funds and practices most deserving of scrutiny. Richards opined that routine surveillance could also reduce the time spent by both the SEC and funds on regular inspections, by enabling the SEC to conduct risk assessment analyses at other times.
Richards provided examples of the types of information that may be of use for a surveillance program for mutual funds, including “NAV per share; the shadow price for money market funds; the total net assets and shares outstanding; percentage of the portfolio that is fair valued; percentage of the portfolio that is illiquid; a description of each share class and the primary investment objective or style of the fund.” Specific information concerning each portfolio security held by a fund, Richards added, as well as the identity of the audit firm and the custodian of customer assets for advisers, may also be useful in this regard.
Turning to the issue of data delivery, Richards highlighted the recent experience that the SEC and investment advisers have had with respect to electronic data and advanced two potential proposals for the appropriate method for data delivery. One such method would be for mutual funds to provide data to the SEC in XML-tagged format via EDGAR using similar procedures to those currently used to file Forms 13F and SH. The other potential approach described by Richards would be for funds to post data in a tagged format to a shared information technology space for the SEC to view and download.
In closing, Richards emphasized that information technology and data analysis hold great promise for mutual fund oversight and encouraged the SEC and the mutual fund industry to further explore the ideas outlined in her speech.
|See a copy of Director Richards’s speech|
SEC Rules and Regulations
New Form D Filing Deadline Approaches on March 16, 2009
In the case of an ongoing offering for which an old Form D (or the latest amendment thereto) was filed prior to March 16, 2008, an annual amendment on the new electronic Form D will have to be submitted no later than March 16, 2009. Paper copies of such amendments are required to be filed in each state where a Form D was previously filed.
This requirement is pursuant to amendments that mandate electronic filing and alter the information requirements of Form D, which were adopted by the SEC in February 2008 and reported in greater detail in the February 15, 2008 Investment Management Regulatory Update.
In order to file electronically, issuers must obtain a Central Index Key and a set of EDGAR access codes from the SEC. Issuers that have already received the necessary codes may use their previously assigned codes to make Form D filings. In addition, it is important to note that issuers must continue to file Form Ds with the states pursuant to state blue sky laws in paper format, as states are not yet equipped to receive electronically filed Form Ds.
If you have any questions on whether your fund is subject to this requirement, please contact your regular Davis Polk contact.
|See a copy of the Release|
|Obtain EDGAR codes|
|File a Form D electronically|
SEC Publishes Rules Requiring Use of Summary Prospectus for Mutual Funds
On January 13, 2009, the SEC published the adopting release and text of amendments (the “Adopting Release”) requiring mutual funds to provide a concise summary prospectus to appear at the front of a fund’s detailed statutory prospectus. The Adopting Release also contains rules which allow mutual funds to satisfy prospectus delivery requirements by mailing only a summary prospectus to investors, provided that the summary prospectus, the statutory prospectus and other specified information are available online. The new disclosure rules were initially proposed in November 21, 2007 and were approved on November 19, 2008. For a more detailed discussion of these rules, see the December 3, 2008 Investment Management Regulatory Update and the December 13, 2007 Investment Management Regulatory Update.
The Adopting Release also contains amendments to Form N-1A relating to exchange traded funds (“ETFs”), which were separately proposed in March 2008 (see the April 14, 2008 Investment Management Regulatory Update). The amendments are intended to improve disclosure for investors that purchase shares in exchange traded funds in the secondary market on national securities exchanges. The SEC did not adopt amendments that would require an ETF to disclose returns based on market share price as well as net asset value or the ETF’s performance relative to its tracking index, for index-based ETFs. The SEC did adopt, as proposed, a requirement that ETFs disclose historical information about the premium and/or discount of the ETF’s market price relative to its net asset value.
The new disclosure rules are effective on March 31, 2009, and funds must begin complying with the form changes on January 1, 2010.
|See a copy of the Adopting Release|
SEC Publishes Final Rules and Proposes Additional Rules for Credit Rating Agencies
On February 2, 2009, the SEC published the text of its new rules for credit rating agencies registered as nationally recognized statistical rating organizations (“NRSROs”). These rules were adopted at the SEC’s December 3, 2008 open meeting. The new rules are generally scheduled to go into effect on April 10, 2009. The SEC also re-proposed additional rules for NRSROs. Comments on the re-proposed rules are due March 26, 2009.
|See the Davis Polk & Wardwell Client News Flash regarding the rules.|
SEC Charges Merrill Lynch For Violations Under the Investment Advisers Act
In a January 30, 2009 press release, the SEC announced that it had charged Merrill Lynch and two of its former investment adviser representatives with violations of the Investment Advisers Act of 1940 (“Advisers Act”).
The SEC found that Merrill Lynch violated Section 206(2) of the Advisers Act and breached its fiduciary duty to clients of its pension consulting services advisory program for failing to disclose certain conflicts of interest and for making misleading statements. Specifically, the SEC alleged that Merrill Lynch and its representatives recommended that its clients use an affiliated directed brokerage service and an affiliated transition management service, without disclosing the significantly higher revenue that it would receive if clients used such affiliated services. In addition, the SEC alleged that Merrill Lynch and its representatives made misleading statements to pension fund clients regarding the process by which it identified money managers. Specifically, the SEC alleged that Merrill Lynch and its representatives told clients that its New Jersey headquarters would select five to eight potential investment managers for a client from a list of over 1,000 candidates, which would then be submitted to the client for consideration. In fact, according to the SEC, Merrill Lynch’s Florida branch office developed its own list of only approximately sixty investment managers, some of which had not been approved by the New Jersey headquarters.
The SEC also charged two former Merrill Lynch representatives with aiding and abetting and causing Merill Lynch’s violation of Section 206(2) of the Advisers Act.
Without admitting or denying these allegations, Merrill Lynch agreed to a censure, and to cease and desist from committing or causing violations of Sections 204 and 206(2) of the Advisers Act. Merrill Lynch also agreed to pay a $1 million penalty to settle the charges. One of the representatives settled with the SEC, agreeing to a censure and to cease and desist from committing or causing violations of the securities laws. The other representative is contesting the SEC’s allegations.
|See a copy of the SEC press release announcing the charges|
Indexed Annuity Providers Sue SEC
On January 16, 2009, a consortium of indexed annuity providers sued the SEC in the U.S. Court of Appeals for the District of Columbia Circuit to overturn Rule 151A under the Securities Act of 1933 (“Securities Act”). As reported in the January 13, 2009 Investment Management Regulatory Update, Rule 151A will allow the SEC to regulate equity-indexed annuities issued after January 12, 2011. Prior to the adoption of Rule 151A, indexed annuities were regulated by individual states, but were not subject to investor protections under the federal securities laws due to an exemption under Section 3(a)(8) of the Securities Act.
The petitioners in the action claim that Rule 151A is unlawful and have publicly stated that the rule will result in excessive costs to the indexed annuities industry. The petitioners initially asked the SEC to delay implementation of the rule until the court renders a decision in the case in order to avoid anticipated costs associated with the implementation of measures to comply with Rule 151A. The petitioners withdrew this request, however, in exchange for the SEC’s agreement to jointly seek expedited review by the court, a motion for which was filed on January 27, 2009. In the motion for expedited review, the petitioners request that the court hear arguments in the case in May or June of 2009.
|See a copy of the complaint|
|See a copy of the motion for expedited review|
If you have any questions regarding the matters covered in this Regulatory Update, please contact any of our Investment Management Group lawyers listed below or your regular Davis Polk contact:
John Crowley, Partner
212-450-4550 | firstname.lastname@example.org
Nora Jordan, Partner
212-450-4684 | email@example.com
Yukako Kawata, Partner
212-450-4896 | firstname.lastname@example.org
Leor Landa, Partner
212-450-6160 | email@example.com
Danforth Townley, Partner
212-450-4240 | firstname.lastname@example.org
Sophia Hudson, Associate
212-450-4762 | email@example.com