Connecticut lawmakers proposed three bills last week concerning hedge funds and other private investment funds, which were referred to the Banks Committee of the Connecticut General Assembly. The proposed bills would, among other things:
- set minimum financial qualification requirements for investors in private investment funds,
- mandate certain disclosures to investors and prospective investors of privatev investment funds, and
- require private investment funds established or conducting business in Connecticut to be licensed with the Connecticut Banking Commissioner.
If the proposed bills are passed, they will become effective October 1, 2009. On February 24, 2009, the Banks Committee held a public hearing at which Connecticut Attorney General Richard Blumenthal proposed alternative hedge fund legislation. Below is a summary of the bills proposed by the legislators and the Attorney General as well as pending federal legislation that could impact these various proposals.
Proposed Connecticut Senate Bill No. 953 - Investor Qualification and Disclosure Requirements
This bill sets forth several requirements for "hedge funds" that have offices in Connecticut where employees regularly conduct business on behalf of the funds. While the bill refers only to "hedge funds," its application is broader. The term "hedge fund" is broadly defined to include any "investment company" (as defined in Section 3(a)(1) of the Investment Company Act of 1940) that claims an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 and whose offering of securities is exempt under Regulation D's Rule 506 safe harbor. Thus, a variety of private investment funds, whether or not they are hedge funds in the traditional sense (including venture capital funds, private equity funds, and mezzanine debt funds), would be subject to the proposed legislation. There is also no distinction among funds based on the size (either in terms of number of investors or assets under management) or the investment strategy of the fund. This bill proposes that:
- Beginning on January 1, 2011, no fund may have individual investors who, individually or jointly with a spouse, have less than $2.5 million in "investment assets"1 or institutional investors that have less than $5 million in assets. "Investment assets" is defined as any security, real estate, cash and cash equivalents, commodity interests held for investment purposes, and other forms of investment assets that may be established by the Banking Commissioner. As currently drafted, the bill does not provide for any grandfathering for existing funds that currently have investors who do not meet the proposed minimum financial qualification threshold.
- No more than 30 days before any investment in the fund, the fund manager must disclose to each investor or prospective investor any conflicts of interest or potential conflicts of interest, financial or otherwise, of the manager that would adversely affect the manager's duties and responsibilities to the fund or its investors. In effect, this bill would establish a 30-day waiting period for prospective investors beginning with the date of any such disclosure.
- The manager must disclose in writing to each investor: (1) any material change in the investment strategy or philosophy of the fund or the departure of any of the fund's key personnel; (2) the existence of any side letters provided to investors in the fund; and (3) any major litigation involving the fund or governmental investigation of the fund. However, this bill does not prescribe a time period for such disclosure. These disclosure requirements would only apply to current fund investors and would not mandate changes to information provided to prospective investors. Presumably, the drafters of this bill were relying on the sufficiency of existing state and federal anti-fraud protections relating to disclosure to prospective investors. It is noteworthy that the provision merely requires the disclosure of the existence of any side letters, not the terms of such side letters.
- Beginning on January 1, 2010, and annually thereafter, the manager must disclose in writing to each investor: (1) the fee schedule of the fund, including management fees, brokerage fees, and trading fees; and (2) an audited financial statement including the investor's capital balance. This bill does not indicate the period the financial statement should cover. For funds that have a fiscal year-end of December 31, compliance may require an additional interim audit in order to make timely disclosure by January 1.
Proposed Connecticut House Bill No. 6477 - Licensing of Funds
This bill would require any "hedge fund" or "private capital fund" established or conducting business in Connecticut to apply for a "license" from the Connecticut Banking Commissioner and pay a $500 fee. The fund would also be required to renew the license annually upon payment of a $500 fee and in accordance with regulations adopted by the Connecticut Banking Commissioner. Multiple funds managed by the same manager would each appear to require a separate license in Connecticut. As proposed, it is unclear what types of funds would be governed by this bill because the terms "hedge fund" and "private capital fund" are not defined. Unlike CT Senate Bill No. 953 (discussed above), which limits applicability to funds that claim certain exemptions from federal registration under the Investment Company Act of 1940, this licensing legislation would potentially include all funds, regardless of their registration status. It also seems that this licensing requirement would apply to funds regardless of whether or not their managers are registered as investment advisers at the federal or state level.
Proposed Connecticut House Bill No. 6480 - Disclosure of Financial Information by Funds to Connecticut Pension Investors
This bill would require any "hedge fund" or "private capital fund" domiciled in the state and receiving money from Connecticut pension funds to disclose financial information to prospective pension investors upon request. Such financial information would include, without limitation, detailed portfolio information related to the assets and liabilities of the fund. As with the licensing bill (CT House Bill No. 6477), the terms "hedge fund" and "private capital fund" are undefined. This leaves open the question of what types of funds would be subject to this heightened disclosure requirement. As proposed, there are no limits or restrictions on the types of financial information that may be requested by pension investors and disclosed by the funds.
Alternative Proposal by the Connecticut Attorney General
Attorney General Blumenthal testified this week before the Banks Committee on his proposed alternative hedge fund legislation. The Attorney General began his testimony by stating that Connecticut has an historic opportunity to lead the nation in regulating hedge funds to provide for greater transparency and greater accountability. Risk disclosure and risk control are the two key elements in his proposal to increase the transparency of funds, he said.
The Attorney General's proposal differs from the bills proposed by legislators by: (1) defining "hedge fund" to include any investment company that offers to or solicits investors in the fund in Connecticut or has one or more investors whose residence or principal place of business is in Connecticut; (2) providing timeframes around the disclosures and more specificity as to the types of information that must be disclosed; (3) giving more deference to federal regulation in exempting from registration in Connecticut any fund that has registered with the Securities and Exchange Commission; and (4) requiring that investors in the funds meet minimum asset requirements established by the SEC.
Proposed Federal Legislation
The proposals for state regulation of private investment funds come only weeks after legislation was introduced in Congress to require private investments funds with at least $50 million in assets to register with the SEC, make annual disclosures to the SEC, maintain SEC required books and records, and cooperate with information and examination requests from the SEC.2 The annual disclosures would report: (1) the total number of investors in the fund; (2) the names and current addresses of the investors and the primary accountant and primary broker used by the fund; (3) an explanation of the structure of ownership interests in the fund; (4) financial institution affiliations of the fund; (5) disclosure of any minimum investment commitment; and (6) the value of both fund assets and assets under management of the fund. The legislation may also have the effect of requiring the managers of such funds to register as investment advisers under the Investment Advisers Act of 1940.
While the Connecticut legislature has considered heightened regulation of private investment funds in the past without taking action, these proposals indicate an increased resolve by lawmakers and Attorney General Blumenthal to tighten the rules under which these funds operate. Both federal and Connecticut legislation are in the early stages of the legislative process. It is uncertain what the regulatory framework for private investment funds will look like in the future. Attorney General Blumenthal acknowledged the proposed federal legislation during his testimony to the Banks Committee, but expressed belief that Connecticut should pass legislation now because there is no certainty that federal legislation will be enacted. He stated that although federal regulation of hedge funds is preferred over state regulation, Connecticut legislation is necessary at this time because of what he referred to as the current regulatory "black hole" in which hedge funds operate.
We plan to issue Alerts regarding this proposed legislation as further developments warrant.
Below are links to the full text of the proposed Connecticut and federal bills: