The first session of the 2010 legislative calendar in Connecticut opens with the possibility of Connecticut-based hedge fund managers facing broad conflict of interest disclosure requirements when accepting investor subscriptions. Please click here to access a copy of Raised Bill No. 5053, entitled "An Act Concerning Transparency and Disclosure," co-sponsored by Senator Bob Duff (D-Norwalk) and Representative Ryan Barry (D-Vernon), co-Chairs of the Banks Committee, and Banks Committee Ranking Member Representative John Stripp (D-Weston). The Raised Bill continues a trend, established in the 2009 session, focusing on transparency and disclosure requirements and moving away from manager registration and reporting.
In our May 27, 2009 Client Alert, we wrote about Amended Substitute Senate Bill No. 953, "An Act Concerning Hedge Funds" (the "2009 Proposal"). That Bill, co-sponsored by these same three legislators, would have impacted investment advisers to all "private investment funds" including private equity funds, venture capital funds, real estate funds, and hedge funds that either (i) have offices located in Connecticut or, significantly, (ii) offer or sell their interests to Connecticut investors ("Subject Advisers"). Had it been enacted into law, the 2009 Proposal would have required these Subject Advisers, whether or not registered with the U.S. Securities and Exchange Commission (the "SEC"), to comply with the delivery requirements of Rule 204-3 under the Investment Advisers Act of 1940, as amended (the "Advisers Act") – but only insofar as having to disclose "material conflicts of interest of the investment adviser." The 2009 Proposal passed the Connecticut Senate by a vote of 24 to 12, but expired without House action at the close of the 2009 legislative session.
Unlike the 2009 Proposal, which applied to "private investment funds," the Raised Bill applies only to advisers to Connecticut hedge funds. For the purposes of the Raised Bill, a "hedge fund" means any investment company as defined in Section 3(a)(1) of the Investment Company Act of 1940, as amended (the "Investment Company Act"), that:
- claims an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act;
- offers securities in reliance of the exemption under the private offering safe harbor criteria in Rule 506 of Regulation D of the Securities Act of 1933, as amended;
- meets any other criteria as may be established in regulations adopted by the Connecticut Banking Commissioner;and
- is "located in" Connecticut – meaning it has an office in Connecticut where employees regularly conduct business on its behalf.
The 2009 Proposal was notably broader than the Raised Bill, applying to advisers to all types of "private investment funds" and capturing within its scope both those with a Connecticut office or, even if outside of Connecticut, those who offer or sell securities to investors in Connecticut.
Another important (and in our opinion, troubling) difference between the Raised Bill and the 2009 Proposal is the formulation of the actual disclosure obligation set forth in the Raised Bill regarding "conflicts of interest."
Section 1(b) of the Raised Bill requires an adviser to a hedge fund, whether or not registered with the SEC or a State securities regulatory authority, to deliver to every prospective and current investor, at least 30 days prior to investment, a statement of any "financial or other interests the investment adviser may have that conflict with or are likely to impair the investment adviser's duties and responsibilities to the fund or its investors."
As most hedge fund managers and investors know, the anti-fraud provisions of both the federal and state securities laws require extensive disclosure of exactly this type of information in the offering memorandum used to solicit prospective investors (and current investors making additional capital contributions or commitments) to a fund. Manager conflicts of interest with respect to overlapping funds, allocation of investment opportunities and personal financial interests are customarily described in painstaking detail. Often, this disclosure occupies multiple pages of the offering memorandum, and details both the process the manager will employ to resolve such conflicts and the notification it will provide to its investors.
In addition to conflicts of interests disclosures hedge fund managers make in their offering memoranda, SEC registered investment advisers ("RIAs") are required under Item 9, Part II of SEC Form ADV to disclose "Participation or Interest in Client Transactions," including whether the RIA "recommends to clients that they buy or sell securities or investment products in which the [RIA] or a related person has some financial interest," and whether it "buys or sells for itself securities that it also recommends to clients." Part II of Form ADV, or a written document containing at least the information required by Part II of Form ADV, must be provided by the RIA to investors not less than 48 hours prior to entering into any investment advisory contract (or at the time of entering into any such contract, if the advisory client has a right to terminate the contract without penalty within 5 business days after entering into the contract). Connecticut law has a similar requirement for Connecticut-registered advisers who have less than $25 million in client assets.
In a very real sense, the Raised Bill, if enacted, would simply add an unnecessary layer of compliance on Connecticut hedge fund managers – and one that provides no additional benefits or protections for investors.
The U.S. Congress is clearly re-engaged in efforts to enact meaningful financial reform legislation, including proposals that will require virtually all managers of pooled capital like hedge funds to register as investment advisers with either the SEC or their home States. As part of this sweeping reform effort, the National Association of State Act Administrators ("NASAA"), the trade group that represents the interests of State securities regulators, continues to press Congress for an increase from $25 million to $100 million or more in the dividing line (drawn by the National Securities Markets Improvements Act of 1997 ("NSMIA")) between State and federal registration and supervision of investment advisers. If adopted into law, these federal proposals will result in substantially greater authority for the Connecticut Securities Division over Connecticut-based hedge fund managers.
In our opinion, the Raised Bill is duplicative of existing federal and state securities law requirements, and will saddle Connecticut-based hedge fund managers with a burden not shared by their competitors in other States. In a highly competitive industry where hedge fund managers have asset-light, "plug-and-play" operations, the possibility of a migration across the border to neighboring States cannot be underestimated. Connecticut can ill-afford the loss of high-paying jobs and tax revenue associated with these enterprises.
To the extent the Connecticut legislature feels compelled to act in this area while the Congress continues to move toward investment adviser reforms, we think the formulation of the disclosure requirement set forth in the 2009 Proposal (requiring delivery of Form ADV Item 9 information), along with a sun-setting provision if the Congress does act before December 31, 2010, is far more preferable than the nebulous conflicts standard and impractical advance delivery timeframe set forth in the Raised Bill. Unfortunately, if the Congress is unable to pass such legislation before the end of 2010, Connecticut-based hedge fund managers (including those who are RIAs) may be faced with the prospect of an additional compliance mandate beginning in 2011 if the Raised Bill is enacted.