New legislation that proposes to increase federal oversight of hedge funds has been introduced over the past several months in both the United States Senate and the House of Representatives. In the Senate, S. 344, the "Hedge Fund Transparency Act", was introduced to amend the Investment Company Act of 1940 and the Investment Advisers Act of 1940, (Advisers Act). The Senate bill would authorize the Securities and Exchange Commission (SEC) to require federal registration of hedge funds and would require hedge funds to implement anti money-laundering programs and to report suspicious transactions. In the House, H.R. 711, the "Hedge Fund Adviser Registration Act of 2009", was introduced and proposes to amend the Advisers Act to remove the current exemption from registration for investment advisers that have fewer than 15 clients. Another House bill, H.R. 713, the "Hedge Fund Study Act" would require the President's Working Group on Financial Markets to conduct a study to identify and analyze certain characteristics, trends, and risks associated with the hedge fund industry.
Richard Baker, President and Chief Executive Officer of the Managed Fund Association (MFA), testified on May 7, 2009, at a hearing of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises. He announced the MFA's support for registration of investment advisers to hedge funds under the proposed House bill H.R. 711. The MFA is a trade association representing professionals in hedge funds, funds of funds and managed futures funds, including the largest hedge fund groups in the world.
As noted above, H.R. 711 would remove the existing "private adviser" exemption which provides an exemption from registration under the Advisers Act if an investment adviser has had fewer than 15 clients in the preceding 12 months. Because a fund itself is considered to be a single "client" for these purposes, investment advisers to fewer than 15 funds and other clients may currently be exempt from registration under the private adviser exemption. It is important to note that H.R. 711 would not require registration of the hedge fund itself, but rather the investment adviser to the fund. As registered investment advisers, fund advisers would be required to, among other things, (i) submit to inspections and examinations by the SEC; (ii) meet specific periodic reporting requirements; (iii) provide detailed disclosures to regulators and clients/investors; (iv) maintain specific books and records, a code of ethics and compliance policies; and (v) abide by the Advisers Act and related rules regarding certain trading activities, the receipt of performance fees, maintenance of client accounts and client solicitation.
Baker expressed the MFA's general support for the removal of the small adviser exemption under proposed H.R. 711 and made suggestions for specific provisions regarding the regulation of hedge funds and their advisers that Congress should include in the final legislation. First, the MFA suggested that because the costs of regulatory compliance can be great, Congress should include an exemption from registration for small hedge fund advisers with a de minimis amount of assets under management, but did not suggest a specific amount. The MFA urged that such de minimis threshold be consistent with state regulation of investment advisers and not create duplication of registration or reporting.
While acknowledging the need for reporting requirements that provide regulators sufficient information for oversight, Baker also expressed the MFA's concern over hedge fund adviser reporting obligations, urging that such requirements should not be overly broad and onerous. In addition, Baker noted that the sensitive, proprietary information that hedge fund advisers and other industry participants would be required to disclose to the SEC should be protected from public disclosure because of the risk that members of the public may act on incomplete data, which could increase risk to individual investors and the financial system as a whole. He also stressed that the ability of market participants to establish and exit from market positions in an economically viable manner may be hindered by wide public disclosure of such information.
In addition, the MFA takes the position that this legislation should not be used to impose regulatory restrictions on, or to set standards for, certain hedge fund activities such as the investment strategies employed by hedge funds, the use of leverage, and the establishment of capital requirements. Baker also cautioned against using hedge fund regulation as a means to regulate broader market issues such as short-selling and insider trading. Issues that are not unique to the hedge fund industry, but rather impact all market participants, should not be addressed through hedge fund regulation in his view. Moreover, Baker emphasized the critical role that industry best practices and vigorous due diligence play as complements to regulatory oversight in promoting market integrity and protecting investors.
Baker separately addressed the need for systemic risk regulation and noted that the hedge fund industry as a whole should take part in a regulatory framework with systemic risk oversight. However, Baker stressed that individual hedge funds themselves do not pose systemic relevance because they are narrowly focused, are relatively small compared to large financial institutions, and do not possess some of the attributes of other financial institutions that can impact the overall financial system during a crisis, such as the provision of payment and settlement services to the public. The MFA supports a systemic risk framework that features: (i) a systemic risk regulator with oversight of the key features of the entire financial system, (ii) confidential reporting to the regulator by entities identified as having systemic relevance, and (iii) a broad mandate for the regulator to take action when necessary to protect the financial system and adequate authority to prevent systemic problems and address such problems once they occur.
H.R. 711 is currently under consideration by the House Financial Services Committee. We will continue to monitor the progress of all of the proposed legislation impacting hedge funds and their managers and will provide updates accordingly.