Amid daily news stories and statements from U.S. public officials about bolstering financial system transparency through increased regulation, two U.S. senators have introduced a bill called the Hedge Fund Transparency Act (the Bill). If passed, the Bill would have significant implications not only for hedge funds, but for venture capitalists, private equity funds and other private funds, including potentially Canadian-domiciled and other offshore funds (Private Funds) that rely on commonly-used exemptions from the definition of “investment company” under the Investment Company Act of 1940 (the ICA). A statement issued by one of the Bill’s sponsors makes clear the intention to cast a wide net:
The Bill imposes these requirements on all entities that rely on Section 80a-3(c)(1) or (7) [of the Investment Company Act] to avoid compliance with the full set of the Investment Company Act requirements. A wide variety of entities invoke those sections to avoid those requirements and SEC oversight, and they refer to themselves by a wide variety of terms – hedge funds, private equity funds, venture capitalist, small investment banks, and so forth. Rather than attempt a futile exercise of trying to define the specific set of companies covered by the Bill and thereby invite future claims by parties that they are outside the definitions and thus outside the SEC’s authority, the Bill applies to any investment company that has at least [U.S]$50 million in assets or assets under its management and relies on Sections 80a-3[(c)](1) or (7) to avoid compliance with the full set of Investment Company Act requirements. 1
Under the Bill, the commonly-used exemptions found in §3(c)(1) and §3(c)(7) of the ICA would no longer exempt Private Funds from being considered investment companies. Rather, the Bill would consider any Private Fund relying on either of those exemptions to be an investment company, but would exempt those Private Funds from the applicability of the substantive provisions of the ICA that are traditionally applicable to investment companies.2 The exemption currently found in §3(c)(1) of the ICA is available to Private Funds beneficially owned by not more than 100 persons while the §3(c)(7) exemption is available to Private Funds whose outstanding securities are owned exclusively by persons who, at the time they acquired the securities, were “qualified purchasers.”
According to the Bill however, if a Private Fund that is an investment company has assets, or assets under management, of U.S.$50 million or more, it will only be able to claim one of the new exemptions if it (1) registers with the U.S. Securities and Exchange Commission (SEC); (2) files a detailed annual information form with the SEC, including disclosure of, among other things, the name and address of each natural person who is a beneficial owner of the Private Fund and any company with an ownership interest in the Private Fund; (3) maintains its books and records in accordance with SEC rules; and (4) cooperates with any request for information or examination by the SEC. In addition, all Private Funds that claim one of the new exemptions would be required to establish an anti-money laundering program and report suspicious transactions.
Generally, a Canadian or offshore Private Fund that offers interests privately to U.S. investors in reliance on §3(c)(1) must count its U.S. investors in determining compliance with the 100-person limit, but may exclude offshore investors.3 Similarly, the staff of the SEC's Division of Investment Management has taken the view that an offshore Private Fund seeking to rely on §3(c)(7) is not subject to the qualified purchaser requirement with respect to its offshore investors.4 If the Bill is enacted as presently drafted, however, it appears that all Private Funds that currently rely on the exemptions in §3(c)(1) or §3(c)(7) in any respect would be considered investment companies for the purposes of the ICA, unless they can rely on a different exemption. Those with assets, or assets under management, of U.S.$50 million or more would only be exempted from the substantive provisions of the ICA if they complied with the new proposed registration and reporting requirements.
The Bill provides scant details on what “registration” with the SEC would entail, and lacks clarity in other areas as well. For example, one portion of the Bill implies that Private Funds will need to “receive an exemption” from the SEC, but it does not elsewhere describe any sort of application process.5 The exemptions currently found in §3(c)(1) and §3(c)(7) are self-executing and do not require an application to the SEC.
If passed, the Bill would require the SEC to issue forms and guidance within 180 days after passage. The bill would also give the SEC authority to “make a rule to carry out this Act.”
Given the recent congressional focus on financial system regulation and the calls for increased transparency, there appears to be momentum building for mandating increased disclosure by previously unregulated Private Funds.