On Tuesday, June 17, the Department of Treasury issued a white paper on financial regulatory reform titled, “A New Foundation: Rebuilding Financial Supervision and Regulation.” The white paper includes a series of proposed reforms, including a requirement that advisers to hedge funds, private equity funds and venture capital funds register with the SEC and that they report information about the funds they manage so that regulators can assess the systemic risk the funds may pose individually or collectively. A copy of the white paper can be found at: www.financialstability.gov/docs/regs/FinalReport_web.pdf. This client alert reviews these registration and reporting proposals, as well as other proposals that may impact advisers to private funds.
In rationalizing its registration and reporting proposals, the Department of Treasury noted the recent “explosive growth” in privately owned investment funds and that US laws generally do not require such funds (or their advisers) to register with a federal financial regulator. The Department of Treasury further explained that, in the recent financial crisis, hedge fund de-leveraging contributed to the strain on financial markets. Moreover, federal financial regulators lacked reliable and comprehensive data necessary to assess this type of market activity since hedge funds and their advisers were not required to register. The Department of Treasury also observed that “there is a compelling investor protection rationale to fill gaps in the regulation of investment advisers and the funds they manage.” As a result, the Department of Treasury believes that requiring SEC registration of advisers to private funds would allow data to be collected and permit “an informed assessment” of (1) how private funds change over time and (2) whether any funds are “so large, leveraged or interconnected that they require regulation for financial stability purposes.”
Registration of All Advisers to Hedge Funds and Other Private Funds
As a threshold matter, the Department of Treasury calls for the registration of all advisers to hedge funds and other private pools of capital. The proposal specifically includes advisers to private equity funds and venture capital funds. The proposal stands in contrast to earlier efforts by the SEC to require registration of only hedge fund advisers, but not private equity fund advisers. See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Advisers Act Release No. 2333 (Dec. 2, 2004). The SEC’s previous efforts to require the registration of hedge fund advisers attempted to carve out private equity fund advisers by generally looking to whether a fund had at least a two year lock up. The Department of Treasury proposals make no such distinction.
The Department of Treasury proposals, however, would exclude from the registration requirement those private fund advisers whose assets under management fall below “some modest threshold.” We expect that any such threshold would not exceed $100 million in assets under management and may actually be significantly lower. We note for example that current SEC regulations require registration of any adviser with at least $30 million in assets under management. Advisers with fewer assets under management generally must look to state laws to determine whether to register with the states.
The Department of Treasury also calls for “national authorities” to implement by the end of 2009 the requirement that private fund advisers register with the SEC. This aspect of the proposal is somewhat vague. Presumably, Congress would need to pass legislation to amend the Advisers Act. (A number of bills have been introduced in Congress recently that would amend the Advisers Act, most notably by removing (or amending) Section 203(b)(3) of the Act which generally exempts from registration advisers who have 14 or fewer clients.) Thereafter, the SEC would likely need to adopt additional rules under the Advisers Act to implement any amendments to the Act. The SEC also would likely provide some compliance grace period, perhaps up to a few months, following the adoption of any new rules.
Reporting by Registered Private Fund Advisers
In addition to the general proposal calling for the mandatory registration of private fund advisers, the Department of Treasury proposes that private fund advisers also submit additional regulatory reports. More specifically, the Department of Treasury has proposed reporting to the SEC on a confidential basis by funds (or presumably their advisers) of (1) the amount of assets under management; (2) borrowings; (3) off-balance sheet exposures; and (4) “other information necessary to assess whether the fund or fund family is so large, highly leveraged or interconnected that it poses a threat to financial stability.” The Department of Treasury suggests that the SEC should share those reports with the Federal Reserve. Finally, the Department of Treasury calls for implementation of the proposal by the end of 2009. As with the registration requirement, we expect that the effective date of any additional reporting requirements may take longer than the end of 2009.
Additional Proposals for Registered Private Fund Advisers
The Department of Treasury also proposes that “all investment funds” advised by an SEC registered adviser should be subject to recordkeeping requirements and requirements with respect to “disclosures to investors, creditors and counterparties.” The Department of Treasury further proposes that the SEC should conduct regular examinations of such funds (and presumably their advisers) to monitor compliance with the recordkeeping, disclosure and reporting requirements.
Regulation as Tier 1 “FHCs”
The Department of Treasury further proposes that the Federal Reserve should determine whether any private funds or private fund families meet Tier 1 FHC criteria and should be supervised and regulated as Tier 1 FHCs. According to the Department of Treasury, Tier 1 FHCs would be those “firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness.” Tier 1 FHCs would be subject to further oversight and regulation by the Federal Reserve, in consultation with a newly created Financial Services Oversight Council. (The Council, chaired by Treasury, would help “fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities,” and would replace the President’s Working Group on Financial Markets.)
Tier 1 FHCs would be subject to heightened prudential standards, including, among others, capital requirements, liquidity standards, and risk management standards. As proposed, a financial firm would be deemed a Tier 1 FHC based on factors that include (1) the impact that a firm’s failure would have on the financial system and economy; (2) the firm’s combination of size, leverage and degree of reliance on short-term funding; and (3) the firm’s role as a source of credit for households, businesses and state and local governments, as well as the financial system generally.
Additional Proposals for the Financial Markets
In addition to the proposals specific to private fund advisers, the Department of Treasury also proposes a number of additional steps that may impact private fund advisers. These additional proposals include that:
- A Financial Services Oversight Council of financial regulators be created to identify emerging systemic risks and improve interagency cooperation.
- The SEC continue it efforts to increase the transparency and standardization of the securities markets and receive authority to require reporting by issuers of asset backed securities.
- All OTC derivatives markets, including credit default swap markets, be subject to comprehensive regulation.
- The CFTC and the SEC make recommendations to Congress for changes to statutes and regulations that would harmonize the regulation of futures and securities (while acknowledging that the CFTC should be able to maintain its enforcement authority over registered CPOs).
- Each national authority put in place guidelines to align compensation with long-term shareholder value and to promote compensation structures that do not provide incentives for excessive risk taking (but not necessarily reaching the private fund industry).