On January 29, 2009, Senators Charles Grassley (R-Iowa) and Carl Levin (D-Mich) introduced S. 344, "The Hedge Fund Transparency Act of 2009." The bill would subject hedge funds managing $50 million or more to the same requirements under the Investment Company Act ("ICA") as mutual funds, unless they comply with various requirements, including registering with the Securities and Exchange Commission, disclosing certain required information, and cooperating with SEC regulatory examinations and requests for information.
In a statement introducing the bill, Senator Levin explained its rationale and hinted at the prospect of broad SEC examinations undertaken pursuant to the bill: "If the events of the last year have taught us anything, it's that we need to regulate firms that are big enough to destabilize our economy if they fail. It's time to subject financial heavyweights like hedge funds to federal regulation and oversight to protect our investors, markets, and financial system."
Notwithstanding the name of the bill, the reach of the proposed legislation appears to extend well beyond hedge funds, to private equity funds, venture capital funds, real estate funds and other vehicles (collectively, "private funds") with $50 million or more in assets. Accordingly, fund managers, investors and other persons associated with any of these investment vehicles will be affected by the bill if it is enacted unchanged.
The ICA requires mutual funds and other entities within the statutory definition of "investment companies" to register with the SEC, make certain disclosures, and abide by layers of ongoing regulatory oversight, filing obligations and various limitations on conduct, transactions and practices. Private funds typically avoid these burdens by fitting within the exceptions to the definition of "investment company" set forth in Section 3(c)(1) of the ICA (which exempts funds with no more than 100 investors) or Section 3(c)(7) of the ICA (which exempts funds owned exclusively by "qualified purchasers," as defined in Section 2(a)(51) of the ICA).
Private funds also avoid SEC registration of their offerings under the Securities Act of 1933 by relying on the exemption from registration afforded by Regulation D.
The SEC previously attempted to regulate hedge funds through the adoption of rules promulgated under the Investment Advisers Act of 1940 ("IAA"). These rules were overturned, however, by the District of Columbia Circuit Court of Appeals in Goldstein v. SEC , 451 F.3d 873 (D.C. Cir. 2006). The court in that case held that the SEC's rules were arbitrary and inconsistent with Section 203(b)(3) of the IAA, which exempts from registration any investment adviser who, during the course of the preceding 12 months, had fewer than 15 clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under the ICA. The following year, Senator Grassley introduced S. 1402, "The Hedge Fund Registration Act of 2007," which would have amended the Investment Advisers Act to require hedge fund registration, but the bill was never considered by Congress.
The Grassley-Levin Bill
The newly-proposed legislation would make three significant changes to the structure of the ICA. First, it would strike the definitional exceptions contained in Sections 3(c)(1) and 3(c)(7), thereby bringing private funds within the definition of "investment company." Second, it would insert into Section 6 of the ICA new Sections 6(a)(6) and 6(a)(7), which correspond to the substance of Sections 3(c)(1) and 3(c)(7). Third, it would insert new Section 6(g), which would provide that an investment company with assets, or assets under management, of not less than $50 million, is exempt under Sections 6(a)(6) and 6(a)(7) only if it meets certain requirements. The bill would thus transform provisions under which a private fund is currently deemed not an "investment company" subject to the ICA, into provisions providing the fund only a conditional exemption from the provisions of the ICA.
Under the bill, the four conditions under which an investment company with at least $50 million in assets or assets under management could claim exemption from the registration and other requirements of the ICA are:
- that it register with the SEC;
- that it file an information form with the SEC, and update it at least once every 12 months, disclosing:
- the name and current address of (a) each natural person who is a beneficial owner of the investment company; (b) any company with an ownership interest in the investment company; and (c) the primary accountant and primary broker used by the investment company;
- information regarding the structure of ownership interests and number of limited partners, members or other investors in the investment company;
- minimum investment commitments required of a limited partner, member or other investor in the investment company;
- any affiliations the investment company has with other financial institutions; and
- the current value of assets and assets under management;
- that it maintain such books and records as the SEC may require; and
- that it cooperate with any SEC request for information or examination.
The bill would also require any investment company relying on the Section 6(a)(6) or 6(a)(7) exemptions to establish an anti-money laundering program and report suspicious transactions under Subsections 5318(g) and (h) of the Bank Secrecy Act.
Analysis: The Proposal Would Likely Extend Beyond Hedge Funds, and Could Lead to a New Regime of Examination and Oversight
The proposed legislation does not make clear what the eventual focus or limits will be on what the SEC will eventually require as information from the class of funds subject to the new rules. Nor does it make clear the scope of any regulatory examinations that would be undertaken pursuant to this authority. The bill, were it to become law, could represent the first step towards regulation of private funds' risk and trading practices, and oversight of the effect their ability to bring large amounts of capital to bear has on markets.
The legislation largely leaves intact the current approach to offerings and exemptions, but overlays a new layer of registration and information disclosure for large ($50 million and up) funds. Significantly, as noted above, while hedge funds are the apparent focus of the proposed legislation, the legislation appears to apply to private equity funds, venture capital funds, and other types of vehicles as well.
As proposed, reliance on the exemptions contained in ICA Sections 3(c)(1) and 3(c)(7) will still be possible, but it will be conditioned on the funds' registering with the SEC and the filing of required additional information. The registration requirement would apply to the funds themselves, and not the fund managers.
The proposed legislation does not fully describe what registration would entail, but it would at a minimum involve the filing of an initial information statement with not less than annual updates. The requirement that investment companies disclose the identities of their beneficial owners initially created some consternation that funds would be required to disclose the names of investors in the fund. On February 5, a week after the bill was introduced, Senators Grassley and Levin issued a statement clarifying that the bill would not require disclosure of hedge fund clients who merely invest in the fund. Rather, it would require disclosure of the hedge fund's "beneficial owners," that is, those who profit from the fees generated in operating the fund.
The identities of those owners, together with the other required disclosures, would be publicly available, but there is no indication whether Reg D private placement memoranda or similar documents would be required to be filed as exhibits. This issue would likely be fleshed out in the SEC rule-making process that would follow the enactment of legislation -- although Senators friendly to the fund manager universe may well seek to attach riders to the bill specifically prohibiting such public filings.
In addition, as noted above, funds registered under this legislation would be required to maintain certain books and records that would be subject to SEC examination, to cooperate with further SEC informational requests and to comply with anti-money laundering procedures (which they already do). The SEC would be empowered to adopt detailed rules to flesh this all out and administer it.
As presently proposed, it is unclear whether the Senate bill's added layer of regulation would have much impact on funds' fundraising processes, except possibly to add in some delay if the registration process turns out not to be an "effective on filing" sort of approach.
With the Grassley-Levin bill having just been introduced, it is still very early in the game. It is unclear what amendments may be made to the bill, whether the resulting bill will be enacted, and, in the event of passage, what the SEC's enabling regulations may provide. Indeed, during the same week that this bill was introduced in the Senate, Representatives Michael Castle (R-Del) and Michael Capuano (D-Mass) introduced a bill in the House that would, like the earlier Grassley bill, seek to require hedge fund registration by amending the IAA. Given the potential importance of the issues to fund managers and others in and out of the private fund industry, the Senate bill and other similar legislative efforts will bear monitoring as they make their way through Congress.