Legislation has been proposed to implement key aspects of the Obama administration’s plan for financial regulatory reform that was announced on June 17, 2009. The U.S. Treasury Department has released three draft bills addressing registration, investor protection and compensation. The progress of these bills will be of great significance to the investment fund industry. In particular, while the mandatory registration of advisers to pooled investment vehicles appears very likely, there are significant questions with respect to: (1) the new categories of information registered advisers will be required to maintain and report; (2) whether the funds themselves, in addition to the advisers, will be subject directly to reporting and possibly registration; and (3) whether increased oversight will lead to limitations on the investment strategies.
During the week of July 13, the U.S. Treasury Department released two draft bills, the “Investor Protection Act of 2009” (the “Investor Protection Act”) and the “Private Fund Investment Advisers Registration Act of 2009” (the “Private Investment Advisers Registration Act”), which would implement many of the investor protection and fund manager registration initiatives set forth in the Treasury Department’s June 17 white paper, “Financial Regulatory Reform – a New Foundation: Rebuilding Financial Supervision and Regulation.”1 The SEC’s perspective on the proposed legislation was offered, on July 15, by the Director of the SEC’s Division of Investment Management, Andrew Donohue, who testified before the Subcommittee on Securities, Insurance and Investment of the U.S. Senate Committee on Banking, Housing and Urban Affairs about “Regulating Hedge Funds and Other Private Investment Pools.” Finally, on July 21, Representative Barney Frank (D-Mass.), Chairman of the U.S. House of Representatives Committee on Financial Services, introduced H.R. 3269, entitled the “Corporate and Financial Institution Compensation Fairness Act of 2009,” which is based in large part on the Treasury Department’s draft “say on pay” bill for public companies but also includes “enhanced compensation structure reporting” requirements applicable to investment advisers and broker-dealers.
Private Investment Advisers Registration Act
The Private Investment Advisers Registration Act would subject managers of hedge funds, private equity funds and venture capital funds with $30 million or more in assets under management to SEC registration no matter how many clients or funds they manage. There would be a narrow exception from the registration requirement for certain “foreign private advisers.” Among other things, the proposed legislation would amend the Investment Advisers Act of 1940 (“Advisers Act”) as follows:
- Elimination of the Fewer-Than-15-Clients Exemption. The Act would eliminate the “private adviser exemption,” currently in Section 203(b)(3) of the Advisers Act, for managers who do not hold themselves out to the public as investment advisers and have fewer than 15 clients. Accordingly, private fund managers managing $30 million or more in assets would be required to register with the SEC no matter how many clients or funds they advise or manage.
- Partial Elimination of Commodity Trading Adviser Exemption. The Act would eliminate the exemption from registration, currently in Section 203(b)(6) of the Advisers Act, for an investment adviser that is registered with the Commodity Futures Trading Commission as a commodity trading adviser if the investment adviser is an adviser to a “private fund,” which is defined as a fund that (a) would be an investment company under the Investment Company Act of 1940 (“Company Act”) but for Section 3(c)(1) or 3(c)(7) thereof; and (b) either is organized under the laws of the U.S. or of any state or has 10% or more of its securities owned by U.S. persons.
- New Exemption for “Foreign Private Advisers”. There would be a new statutory exemption from SEC registration for advisers that have no place of business in the U.S., fewer than 15 clients in the U.S. during the preceding 12 months, manage less than $25 million in assets attributable to U.S. clients and do not hold themselves out to the public in the U.S. as an investment adviser.
- New Fund Disclosure and Filing Requirements. The Act would authorize the SEC to subject private funds to extensive disclosure and filing requirements, which would be imposed through their SEC-registered investment advisers, which would be required to (i) maintain and file with the SEC reports that include, for each private fund advised by the adviser, the amount of assets under management, use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading and investment positions and trading practices; and (ii) provide such reports and records to investors, prospective investors, counterparties and creditors of the private funds for the protection of investors and the assessment of systemic risk.
- Confidentiality of Fund Reports. The Act states that the SEC “shall not be compelled to disclose” the information required to be filed with the SEC, except in response to requests from Congress or other federal agencies.
In his recent testimony, SEC Director of Investment Management Andrew Donohue expressed support for the registration of investment advisers to hedge funds, private equity funds and venture capital funds, noting that, in the SEC staff’s view, registration is appropriate for any investment adviser managing $30 million or more, and noting the growth and economic significance of private funds and the SEC’s incomplete information about private funds and their unregistered advisers. He testified that investment adviser registration would be beneficial to investors by:
- Providing the SEC with data from advisers about their business operations and the private funds they manage;
- Providing the SEC with authority to conduct compliance examinations designed to identify investment advisers’ conflicts of interest and whether conflicts have been properly disclosed to their clients;
- Permitting oversight of investment advisers’ trading activities to prevent market abuses;
- Requiring private fund advisers to develop internal compliance programs administered by a chief compliance officer; and
- Keeping unfit persons from using private funds to perpetuate frauds.
Significantly, Director Donohue also offered possible approaches in addition to the registration of investment advisers. He praised the proposed adviser registration legislation, but suggested three additional ideas for “provid[ing] the Commission with tools to better protect both investors and the health of our markets.”
First, private funds could be required to register under the Company Act. Such registration would impose governance and liquidity obligations and would restrict fund leverage, trading strategies and transactions with affiliated persons.
Second, Congress could give the SEC the authority to impose requirements on unregistered funds (such as investment restrictions, diversification requirements and governance requirements) and regulate investment terms (such as redemption rights).
Third, Congress could provide the SEC with the rulemaking authority to condition the 3(c)(1) and 3(c)(7) exceptions to the Company Act’s definition of investment company. One condition might be that the funds provide information directly to the Commission.
It is no surprise that the Treasury Department has proposed a bill that would require SEC registration of advisers to private funds with more than a modest threshold of assets under management. An adviser registration bill had been proposed less than one week after the Goldstein2 decision invalidating the prior registration rule (203(b)(3)-2) based on the SEC’s unreasonable use of different definitions of the term “client” in different contexts. Following the economic upheavals in 2008, and the Madoff and Stanford Financial scandals, there have been a series of calls for the registration of hedge fund advisers. Most of the legislative proposals have provided for the abolition of the private adviser exemption as the means to mandate registration. The Treasury bill does this as well, and also seeks to shore up the SEC’s authority by expressly providing the SEC with the ability to “ascribe different meanings to terms (including the term ‘client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.”
The new disclosure and reporting requirements provided in the Treasury bill are noteworthy. The other adviser registration bills had simply abolished the private adviser exemption. As noted above, the Treasury bill also would authorize the SEC to require advisers to maintain and file reports far beyond what advisers have ever been required to do. The bill does not provide much in the way of detail, and the categories of information are potentially extremely broad: “use of leverage (including off-balance sheet leverage),”; “counterparty credit risk exposures”; “trading and investment positions”; and “trading practices.” Given the massive quantities of information that could be called for by these requirements, it is unclear how the Commission would gather, store, review and analyze the data.
Much attention has been paid to the fact that the bill would require the Commission to share this information with the Federal Reserve and the Financial Services Oversight Council to permit them to assess the systemic risk of the fund or whether the fund should be treated as a Tier 1 financial holding company and be subject to additional scrutiny and limitations. These are novel concepts for non-banking entities: what systemic risk means, how it should be evaluated and monitored, and what types of investment limitations or restrictions, if any, should be imposed. It is also important to note that the bill would authorize the Commission to require advisers to share the new information to be disclosed regarding the funds with “investors, prospective investors, counterparties, and creditors.” Disclosures such as this raise significant issues with respect to the confidentiality of the adviser’s proprietary information and competitive advantages. The bill provides that the Commission will not be compelled to disclose the information provided to it by advisers but no such protection would apply to the confidential information that advisers would be required to disclose to counterparties, investors and other private parties.
The new reporting requirements in the Treasury bill also raise a more general question as to whether the SEC will seek to impose limitations on the investment strategies of private funds, such as regulatory rules on capital requirements, use of leverage and trading restrictions. As a general matter, the Treasury bill on adviser registration, as well as the other Treasury bills, does not proscribe specific requirements but instead provides the SEC with broad grants of authorization to regulate as it sees fit. This may raise questions as to how far Congress was asking the SEC to go, and whether new legislation in this area should be specifically tailored by Congress to address particular concerns (e.g. the need for more “census” type information about private funds), as opposed to simply granting broad discretion to the SEC.
The extra-territorial implications of Treasury’s adviser registration bill also are significant. The bill would provide the SEC with a broad grant of jurisdiction. Any fund, organized under the laws of any jurisdiction, would be subject to the bill if it is 10% or more owned by U.S. persons. Although the bill introduces an exception for “foreign private advisers,” that exception will likely be of limited utility because it does not cover: (1) advisers with any office in the U.S., regardless of the size or function of the office; and (2) advisers with assets under management attributable to clients in the U.S. of $25,000,000 or more. These issues highlight the importance of coordination among regulators in different jurisdictions—a goal noted in the Treasury White Paper but not provided for in the Treasury adviser registration bill.
Finally, it is noteworthy that although the SEC has indicated support for adviser registration, it continues to suggest the possibility of fund registration. Indeed, as noted above, Director Donohue recently reiterated the option of fund registration, and went on to suggest additional ways that the Commission could regulate funds even without formally registering them. The fact that fund registration and other methods of fund regulation are being discussed by the SEC makes adviser registration seem to be the “floor” in the discussion of how far regulation of private funds should go.
Investor Protection Act
The proposed Investor Protection Act would grant broad rule-making authority to the SEC with respect to various aspects of the relationship between investment professionals and their clients, including establishing a uniform fiduciary standard for broker-dealers and investment advisers who provide investment advice to retail clients and requiring simple and clear disclosure by investment professionals to clients regarding compensation, conflicts of interest and other aspects of their relationship. The Act also would broaden the legal bases upon which the SEC may bring aiding and abetting cases and expand the SEC’s ability to bar or suspend regulated entities and persons.
Regulation of Investment Professionals
The Investor Protection Act would expand the SEC’s regulation of investment professionals in several significant respects. Among other things, the Investor Protection Act would amend the Securities Exchange Act of 1934 (“Exchange Act”), the Company Act and the Advisers Act in the following respects:
- Standards of Conduct. The Act would authorize the SEC to promulgate rules establishing a uniform fiduciary duty standard for both broker-dealers and investment advisers when they are “providing investment advice about securities to retail customers,” however, it does not define what constitutes “providing investment advice” on the part of a broker-dealer, leaving open the issue whether it would extend to a single recommendation or solicitation to purchase a security. Depending upon how broadly SEC rulemaking or guidance define the concept (and thereby determine what activities subject broker-dealers to a fiduciary duty), securities distribution practices could be significantly impacted.
- Investor Disclosures. The SEC would be required, under the Act, to “take steps to facilitate the provision [by broker-dealers and investment advisers] of simple and clear disclosures to investors regarding the terms of their relationships with [such] investment professionals.”
- Conflicts of Interests/Compensation. The Act would require the SEC to “examine and, where appropriate, promulgate rules prohibiting sales practices, conflicts of interest, and compensation schemes for financial intermediaries (including brokers, dealers, and investment advisers) that it deems contrary to the public interest and the interests of investors.”
- Mandatory Arbitration Provisions. The SEC would be authorized, pursuant to the Act, to prohibit or place restrictions or conditions upon the use of mandatory arbitration agreements with respect to disputes between broker-dealers and investment advisers and their customers.
- Point of Sale Disclosures. The Act would authorize the SEC to promulgate rules requiring that registered investment companies provide a summary prospectus with disclosure of fees and costs to investors prior to the completion of their purchase of investment company shares. (The rules would likely require substantial changes to the manner in which many mutual fund shares are sold by requiring investors to receive disclosure at or before the point of sale. Currently, mutual fund prospectuses are typically delivered at the time of the confirmation of a trade.)
- Investor Advisory Committee and Consumer Testing: The SEC’s new Investor Advisory Committee, which was established in June 2009 to assist the SEC in its consideration of regulatory initiatives regarding new products, trading strategies, fee structures and other issues, would be made permanent. The Act also would authorize the SEC to engage in information-gathering and to implement experimental programs aimed at furthering investor protection and public interest goals.
One of the focal points of the Investor Protection Act is the grant of broadly defined rulemaking authority to the SEC, leaving the agency to decide issues such as what constitutes a “retail customer,” what activities on the part of broker-dealers will subject them to the new fiduciary standard, what disclosures must be made by broker-dealers and investment advisers to their clients, and what restrictions will be placed on mandatory arbitration agreements. If enacted, the Act would stimulate a plethora of rulemaking proposals from the SEC focusing to an unprecedented degree upon the relationships between investment professionals and their clients.
The Investor Protection Act contains the following significant statutory provisions that would go into effect shortly after its enactment:
- New Aiding-and-Abetting Provisions. The Act would add to the Advisers Act a new Section 209(f), stating in pertinent part:
Any person that knowingly or recklessly has aided, abetted, counseled, commanded, induced or procured a violation of any provision of this Act, or of any rule, regulation, or order hereunder, shall be deemed to be in violation of such provision, rule, regulation, or order to the same extent as the person that committed such violation. (emphasis added.)
This proposed statutory aiding-and-abetting standard appears to be the broadest under the federal securities laws. In comparison, the standard under the current controlling person provisions of Section 20(e) of the Exchange Act extends only to “any person that knowingly provides substantial assistance to another person in violation of any provision of this title. . . .”
The Act also would amend Section 15 of the Securities Act of 1933 and Section 48(b) of the Company Act to add a new aiding-and-abetting provision to each that tracks the substantial assistance standard of the Exchange Act but broadens it to include “knowingly or recklessly” providing substantial assistance. Both the current and the proposed aiding-and-abetting provisions are applicable only in the context of SEC actions or proceedings, not in private litigation or arbitration.
- Collateral Bars and Suspensions: The Act would expand the current statutory provisions under hich the SEC can permanently bar or temporarily suspend investment professionals, such as associated persons of a broker-dealer or investment advisor, from continuing their association with whichever type of regulated entity, broker-dealer or investment advisor, they were associated.3 Under the proposed expansion, a permanent bar or suspension imposed upon such a professional could extend beyond that professional’s current association to any “broker, dealer, investment adviser, municipal securities dealer, transfer agent, or nationally recognized statistical rating organization.” For example, an associated person of a broker-dealer, who engages in misconduct relating to the broker-dealer’s business could be barred from associating with an investment adviser and the other above-mentioned regulated entities in addition to being barred from associating with a broker-dealer.
- Whistleblower Incentives and Protection. New Section 21F would be added to the Exchange Act, under which the SEC could make monetary awards to whistleblowers of up to 30% of the monetary sanction in any judicial or administrative action brought by the SEC in which the monetary sanctions successfully imposed exceeded $1 million. A new Investor Protection Fund would be set up for the purpose of funding such whistleblower awards, as well as investor education initiatives. In addition, there would be a statutory prohibition against employer retaliation against whistleblowers.
The enforcement provisions of the Investor Protection Act appear to be attempts to fill in gaps in the Commission’s authority and ability to pursue securities laws violations. The aiding-and-abetting provision would not only add aiding-and-abetting liability to the statutes from which it is currently absent, it also would apply a novel and seemingly broad standard of aiding-and-abetting liability in the investment adviser context. If the proposed legislation is enacted, there would be continuum of aiding-and-abetting standards, ranging from the broadest (in the Advisers Act) to the most narrow (in the Exchange Act) with a mid-point (in the Securities Act and Company Act). The provision on collateral bars and suspensions addresses the concern that different regulators, and the regulated entities they address, are “siloed” off from each other, increasing the risk that enforcement by one regulator will not stop a bad actor from pursuing new victims in a different silo. And the whistleblower provision tries to address the fact that fraud is typically concealed, and providing financial incentives to insiders to come forward with “tips” may often be the best way to discover such wrongdoing.
Corporate and Financial Institution Compensation Fairness Act
On July 21, Representative Barney Frank (D-Mass.), Chairman of the U.S. House of Representatives Committee on Financial Services, introduced H.R. 3269, entitled the “Corporate and Financial Institution Compensation Fairness Act of 2009.” The bill was passed by the House Financial Services Committee on July 28 and is expected to be voted on by the entire House of Representatives prior to the August recess. The Act has two distinct focal points. The first consists of “say on pay” provisions that would apply to publicly traded corporations and provide for a separate, non-binding shareholder vote on executive compensation and “golden parachutes,” as well as bolster the SEC’s rule-making authority with respect to the independence of consultants and advisers to corporate compensation committees. An amendment to the bill provides that institutional investment managers subject to Section13(f) reporting must report annually how they voted on any shareholder votes on the executive compensation issues addressed by this bill. The second focal point of the bill consists of “enhanced compensation structure reporting” requirements that would apply to “covered financial institutions,” a term that would include broker-dealers, investment advisers (as defined by Section 202(a)(11) of the Advisers Act) and “any other financial institution that the appropriate Federal regulators determine should be appropriately included.4 The enhanced compensation structure reporting provisions would go into effect no later than 270 days after the date of enactment of the Act and would require the “appropriate Federal regulators”5 to jointly prescribe regulations that:
- require covered financial institutions to disclose to the appropriate Federal regulator the structure of their incentive-based compensation arrangements offered by such institutions in sufficient detail for the regulator to be able to determine whether the compensation structure:
- Is aligned with sound risk management;
- Is structured to account for the time horizon of risks; and
- Meets such other criteria as the appropriate Federal regulators jointly may determine to be appropriate to reduce unreasonable incentives for employees to take undue risks that (a) could threaten the safety and soundness of covered financial institutions; or (b) could have serious adverse effects on economic conditions or financial stability; and
- prohibit compensation structures and incentive-based payment arrangements, or any feature of such structures or arrangements, that “encourage inappropriate risks” by financial institutions, when measured under the above criteria.
The bill as passed by the House Financial Services Committee includes two amendments particularly noteworthy to hedge fund advisers: (1) a “rule of construction” providing that “[n]othing in this subsection shall be construed as requiring the reporting of the actual compensation of particular individuals”; and (2) an exemption for financial institutions “with assets of less than $1,000,000,000.”
If the draft legislation is enacted, advisers to private funds with $1 billion or more under management can expect to be subject to unprecedented regulatory scrutiny with respect to their performance-based compensation arrangements and possibly outright prohibitions against certain compensation arrangements. This level of oversight of the adviser relationship with clients and investors would be unprecedented. The language of the draft bill is vague and does not provide guidance as to what would or would not be an “appropriate,” risk. Judgments as to the appropriateness of risk may, of course, seem clear in hindsight.