On January 29, 2009, Senator Carl Levin (D-MI) and Charles Grassley (R-IA) introduced a new bill, entitled the “Hedge Fund Transparency Act of 2009” (HFTA), aimed at providing federal securities regulators with greater access to the inner workings of hedge funds. If enacted, the HFTA would amend the Investment Company Act of 1940 (the “1940 Act”) to require all hedge funds (and, potentially, other alternative investment funds) over a certain asset threshold to register with the Securities and Exchange Commission (SEC).
Historically, hedge funds have been permitted to operate mainly outside of the purview of regulators due, in large part, to the fact that only wealthy and, so it is argued, financially sophisticated investors have been permitted to participate in their offerings. Since the collapse of Long-Term Capital Management in 1998, a hedge fund that at its peak had approximately $1.3 trillion in market exposure, there has been growing concern regarding the systemic risks posed to the global financial markets by these privately offered investment vehicles. Because hedge funds (1) represent an increasingly large share of all trading volume on U.S. exchanges; (2) have become a more frequent investment option for pension funds, charities and endowments; and (3) have been established by banks not only for third parties but also as a means of generating additional revenue for the banks, legislators and regulators alike have repeatedly sought ways of asserting control over these entities. Up until now, however, these attempts have largely been unsuccessful. In 2004, the SEC issued a rule requiring registration of the investment advisers that manage hedge funds (the “Hedge Fund Adviser Registration Rule”). This rule was narrowly tailored to advisers of hedge funds (and specifically excluded managers of private equity funds, venture capital funds and other alternative investment funds that require longterm commitment of capital) by limiting its applicability to advisers of alternative investment funds with redemption rights of less than two years. The Hedge Fund Adviser Registration Act was ultimately vacated (the “Goldstein Decision”) shortly after implementation, with the court holding that it was inconsistent with the Investment Advisers Act of 1940 (the “Advisers Act”).
In light of recent volatility in U.S. and global financial markets, the hedge fund industry has come under heightened scrutiny because of the systemic risks potentially posed by some of its larger participants. In December 2008, at hearings held by the House Oversight and Government Reform Committee regarding the relationship between hedge funds and the financial markets, managers of some of the largest hedge funds, along with prominent academics, were virtually unanimous in their agreement that regulators needed to have access to, and actively monitor the risk undertaken by, large hedge funds to help mitigate systemic risks posed by these entities. Senator Levin captured this popular sentiment during his introduction of the HFTA, stating that “the problem is that hedge funds have gotten so big and are so entrenched in U.S. financial markets, that their actions can now significantly impact market prices, damage other market participants, and can even endanger the U.S. financial system and economy as a whole.”1 Accordingly, the introduction of HFTA is an attempt by Congress to address the growing concern that these alternative investment funds have the ability to affect the financial stability of our capital markets, not just their wealthy investors.
Current Regulatory Landscape
Under the current regulatory regime, hedge funds typically conduct their operations in compliance with one of two exceptions to the definition of the term “investment company” under the 1940 Act set forth in Sections 3(c)(1) and 3(c)(7) (the “Investment Company Exceptions”).2 Pursuant to these exceptions, hedge funds that satisfy the requirements of the Investment Company Exceptions are considered exempt from the definition of an investment company and are not subject to the onerous and often costly registration and compliance requirements imposed by the 1940 Act.
While most hedge funds operate outside of the requirements of the 1940 Act, hedge fund managers come under some degree of regulatory scrutiny even following the Goldstein decision. Although the Hedge Fund Adviser Registration Rule was ultimately vacated, Hedge Fund Research, Inc. just released a report that stated that about 55 percent of U.S. hedge fund firms are still voluntarily registered with the SEC and those firms manage almost 71 percent of all U.S.-based hedge fund capital. Moreover, reluctant to lose all oversight of hedge fund advisers, the SEC quickly adopted an anti-fraud rule specifically applicable to advisers of alternative investment funds3 to ensure that some modicum of control and investor protection could be asserted over these types of funds.
HFTA serves as a sharp departure from the current oversight of hedge funds, primarily because of how it redefines alternative investment funds. HFTA would remove the Investment Company Exceptions and make clear that alternative investment funds are, in fact, investment companies subject to SEC oversight. They would not, however, be subject to the same level of regulation as mutual funds, but would be permitted to qualify for an exemption from most of the requirements of the 1940 Act imposed on other investment companies. As Senator Levin noted, this would permit the SEC to bring “hedge funds under the federal regulatory umbrella.””4
The HFTA would accomplish this goal by removing the Investment Company Exceptions and converting the substance of those prior requirements into two additional exemptions, §6(a)(6) and §6(a)(7). These exemptions would be included as part of Section 6 of the 1940 Act, which currently exempts certain investment companies from the full registration and filing requirements. Under this approach, any investment company that qualified under either of these two exemptions, but had assets under management of $50 million or more, would have to satisfy additional requirements in order to maintain its exemption. In order to avail itself of the newly created exemptions, alternative investment funds that met the $50 million threshold would have to (1) register with the SEC; (2) file an informational disclosure form with the SEC; (3) maintain certain books and records; and (4) cooperate with any request for information or examination by the SEC. The information form would have to be filed electronically with the SEC not less frequently than annually and include the following information: (1) the name and current address of (a) each natural person who is a beneficial owner of the fund, (b) any company with an ownership interest in the fund and (c) the primary accountant and primary broker used by the fund; (2) any discussion of the structure of the ownership of the fund; (3) any affiliation the fund has with any other financial institution; (4) the minimum investment amount, if any, required of an investor; and (5) the total number of investors along with the assets of the fund and the assets under management by the fund. This information, including the name and personal address of investors, would then be made available by the SEC to the public for free and in an electronically searchable format. For several reasons, including privacy of investor information, it is likely that this final provision will generate significant feedback both from investors and industry participants alike. In addition the HFTA seeks to mitigate the use of privately offered funds to facilitate money laundering activities. In the event that an alternative investment fund sought exemption from the 1940 Act pursuant to either §6(a)(6) or §6(a)(7) it would be required to establish an anti-money laundering program, report any suspicious transactions and comply with the same requirements as other financial institutions for producing records requested by a federal regulator.
It is worth noting that, unlike the Hedge Fund Adviser Registration Rule, this bill in its current form does not contain any differentiation between hedge funds and other privately offered alternative investment funds, such as private equity funds and venture capital funds. The HFTA applies to all alternative investment funds that would be subject to regulation under the 1940 Act, but for their reliance on the Investment Company Exceptions. Thus, it is not expected that the HFTA will extend to commodity pools. The Hedge Fund Adviser Registration Rule purposely excluded advisers to nonhedge funds due to the belief of the Commission at that time that such funds did not pose the same systemic risk as their hedge fund counterparts. It is not clear at this juncture whether the sponsors of this bill fundamentally disagree with that assumption or whether it was merely an oversight that will be corrected later as the bill proceeds through the legislative process.
Additional Hedge Fund Legislation Introduced
In addition to the HFTA, two additional bills were introduced in the House of Representatives during the last week of January, each aimed at increasing regulatory oversight of hedge funds. On January 27, Rep. Michael Capuano (D-MA) and Rep. Michael Castle (R-DE) cosponsored a bill that would amend the Advisers Act to remove the registration exception for certain investment advisors with fewer than 15 clients, entitled the “Hedge Fund Adviser Registration Act.”5 Pursuant to the court’s holding in the Goldstein decision, the term “client” is defined as the fund managed by the investment adviser, rather than the underlying investors in the fund. Accordingly, many hedge fund managers currently are not required to register, as they do not manage 15 or more funds. While this bill would eliminate this exception and mandate the registration of all hedge fund managers, it would also cast a tremendously wide net requiring the federal registration of all individuals who provide investment advice.
On January 27, Rep. Castle also introduced a bill requiring the President’s Working Group on Financial Markets to conduct a study on the hedge fund industry, including coverage of (1) the changing nature of hedge funds and the characteristics that define a hedge fund; (2) the growth of hedge funds within financial markets; (3) the growth of pension funds investing in hedge funds; (4) whether hedge fund investors are able to protect themselves adequately from the risk associated with their investments; (5) whether the leverage employed by a hedge fund is effectively constrained; (6) the potential risks hedge funds pose to financial markets or to investors; (7) various international approaches to the regulation of hedge funds; and (8) the benefits of the hedge fund industry to the economy and the markets. While it is unlikely, at least in its current form, that the Hedge Fund Adviser Registration Act will be enacted into law, this recent flurry of legislative activity regarding the oversight of the hedge fund industry reflects the appetite of the current administration and the inevitability that change is on the horizon.