As the Senate moves toward a vote on financial regulatory reform, private fund managers should be aware of the key issues that may affect them.
Congress is considering financial regulatory reform proposals that address a broad range of issues, including consumer protection, ratings agencies, systemic risk, executive compensation, private fund adviser registration, the “Volcker Rule,” prudential risk regulation and derivatives. The proposals cover a broad range of parties, including banks, non-banks, rating agencies, mortgage brokers, credit unions, insurance companies, payday lenders, broker-dealers, investment advisers and others. This Alert identifies key legislative issues for private fund managers regarding (1) Adviser Registration, (2) the Volcker Rule, (3) Prudential Risk Regulation and (4) Derivatives.
The Senate is currently debating a bill proposed by Christopher Dodd, chairman of the Senate Committee on Banking, Housing and Urban Affairs (the “Banking Committee”), called the “Restoring American Financial Stability Act of 2010” (the “Dodd Bill”). The House of Representatives in December approved its own version of financial regulatory reform, entitled the “Wall Street Reform and Consumer Protection Act of 2009” (the “House Bill”), although many expect the final resolution and enactment of a financial reform bill to be substantially in the form of the bill ultimately adopted by the Senate.
Private fund advisers also should be aware that the European Union is entrenched in a battle regarding legislation that would reform the regulations for private fund managers. These regulations would, among other things, restrict the ability of non-European managers to market and sell their funds in the European Union.
All of the financial regulatory reform proposals of the past year have included an investment adviser registration component. Key elements regarding investment adviser registration include:
The central component of all of the major adviser registration proposals over the past year is the elimination of the “private adviser exemption” currently in Section 203(b)(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) for managers who do not hold themselves out to the public as investment advisers and have fewer than 15 clients. Many investment advisers that currently are exempt would be required to register. A one-year phase-in period of the registration requirement is included in both the Dodd and House Bills.
Exceptions May Be Provided for the Following:
- Advisers to Smaller Funds. Each of the mandatory registration proposals has included some threshold of assets under management below which Securities and Exchange Commission (the “SEC”) registration is not required. Under the Dodd Bill, advisers to private funds with less than $100 million AUM would not be required to register with the SEC. Such managers would be subject to state registration requirements. One proposal that attempts to have as many advisers registered—either with the SEC or with state securities regulators—is an amendment to the Dodd Bill offered by Senator Jack Reed (the “Reed Amendment”) that would require advisers that fall below the $100 million AUM threshold to either be registered and examined by a state regulator, or to be registered with the SEC.
- Advisers to Venture Capital Funds. Both the House and Dodd Bills exempt from the registration requirement advisers to venture capital funds, though the House Bill would require such advisers to maintain certain records and reports. The SEC will determine what qualifies as a “venture capital fund.” The Reed Amendment would require advisers to venture capital funds to register.
- Advisers to Private Equity Funds. The Dodd Bill would exempt from registration advisers to private equity funds, though it would require them to provide certain reports to the SEC, including any reports the SEC determines to be in the public interest and for the protection of investors. The SEC will determine what qualifies as a “private equity fund.” The Reed Amendment would require advisers to private equity funds to register, as did the House Bill.
- Family Offices. The Dodd Bill would exempt from registration “family offices,” as defined by SEC rulemaking, consistent with prior exemptive orders.
- Foreign Private Advisers. The Dodd Bill would exempt from registration non-U.S. managers with fewer than 15 U.S. clients and less than $25 million AUM attributable to U.S. clients or investors. Such an exemption might still require many non-U.S. advisers to register with the SEC, regardless of whether they are already regulated in their own jurisdiction.
New Reporting Requirements
Since the issuance, on June 17, 2009, of the President’s White Paper on Financial Regulatory Reform, the major proposals regarding private fund managers have included new requirements to increase the amount of reporting that managers must provide to the SEC. Under the Dodd Bill, registered investment advisers, in addition to the existing Advisers Act disclosures, also would be required to report, with respect to each fund they advise:
- The fund’s assets under management;
- Use of leverage;
- Counterparty credit risk exposure;
- Trading and investment positions;
- Trading practices;
- Other information the SEC determines necessary;
- The fund’s valuation policies and practices;
- The types of assets held; and
- Side letter arrangements.
Depending on how the SEC implements such requirements, the reporting obligations might be more or less burdensome (e.g., the SEC may require reporting of all “trading and investment positions,” some modified version of 13F reporting or just maintenance of the books and records necessary to provide such reporting when requested).
In addition to the above “core” provisions regarding adviser registration, the regulatory reform bills have included a range of additional provisions that would affect private fund managers, including a few that may have a significant impact.
- Regulation D Private Offering Process. The Dodd Bill includes a provision that would significantly affect the private offering process. The provision would strike the existing prohibition on states regulating Reg D private offerings. The SEC would promulgate rules designating when a class of securities is a “non-covered” security such that it can be regulated by the states. The SEC also would be required to review within 120 days any filings related to any security issued under Rule 4(2). The Business Law Section of the American Bar Association indicated in a letter to Senators Dodd and Shelby that this provision “would significantly inhibit capital formation without providing any meaningful investor protections.”
- Fiduciary Standard. There have been repeated calls for the imposition upon broker-dealers of a fiduciary standard similar to that applicable to investment advisers under the Investment Advisers Act of 1940. Recently, SEC Chairman Mary Schapiro indicated her support for the fiduciary standard. The Dodd Bill in its early discussion draft form had imposed the fiduciary standard on broker-dealers, though the Dodd Bill currently under debate only requires a study of the issue. At least one proposed amendment to the Dodd Bill would put the fiduciary standard back into the bill. The focus on this issue has become even sharper as lawmakers and regulators consider proprietary trading by large financial institutions and the proper role of these institutions in various types of transactions.
- Additional Studies and Requirements. Both the Dodd and House Bills would mandate a whole new raft of studies, including ones on (i) the feasibility of forming a self-regulatory organization for private funds and (ii) short selling (e.g., recommendations for market improvement and consideration of real-time reporting of short-sale positions). One amendment to the House Bill inserted a number of provisions not previously part of the debate. Two such provisions were at odds with the SEC’s requirements: one that would require daily short-sale reporting, even though the SEC decided not to continue its temporary requirement of weekly short-sale reporting on Form SH, and another that would require “surprise custody exams” of all funds managed by registered advisers—even advisers to pooled vehicles who, in compliance with the SEC’s Custody Rule, deliver timely financial statements to investors. The Dodd Bill does not contain either of these provisions, though numerous possible amendments have been discussed.
THE VOLCKER RULE
- Prohibition on Sponsoring or Investing in Funds. The Volcker Rule would, among other things, prohibit all U.S. banks and their affiliates (as well as foreign banks operating in the U.S. and their affiliates) from “sponsoring” or “investing in” private equity funds or hedge funds (each defined as any entity exempt from registration as an investment company pursuant to Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, or any similar fund as determined by the federal banking regulators).
The term “sponsoring” is defined as: (1) serving as a fund’s general partner, managing member or trustee; (2) selecting or controlling a majority of the fund’s directors, trustees or management; or (3) sharing the same name, or a variation thereof, with the fund for corporate, marketing or other purposes. It is unclear whether a bank or bank-affiliate would be permitted to serve as a subadviser or as an investment manager that is subject to removal at will by a third party (e.g., an independent general partner or board of directors). Such details are to be filled in by new regulations issued by the federal banking regulators, subject to guidance from a new Financial Stability Oversight Council (the “Council”), which also will have the ability to modify or create exceptions to the prohibitions.
Also, the phrase “investing in” is not defined. Accordingly, while it is clear that fund investments made by a bank or bank-affiliate with proprietary money would be prohibited, it is unclear whether the prohibition would also cover investments of third-party money controlled by the bank or bank-affiliate (e.g., investments made in accounts over which the bank or bank-affiliate holds discretion or through funds of funds controlled by the bank or bank-affiliate, although in the latter case, the prohibition on sponsorship appears to prohibit the bank or bank-affiliate from controlling a fund of funds in the first place). As noted above, the federal banking regulators, together with the Council, will be charged with determining such matters.
- Merkley-Levin Amendment. On May 10, 2010, Senators Jeff Merkley and Carl Levin circulated a proposed amendment (the “Merkley-Levin Amendment”) to the Volcker Rule language in the Dodd Bill. The Merkley-Levin Amendment would tighten the Volcker Rule by eliminating most of the discretion granted to the Council and the federal banking regulators to modify or create exceptions to the prohibitions. It would also add a new “anti-evasion” provision that would prohibit otherwise lawful investments or activities, whenever the federal regulators determine that such investments or activities are being used to evade the Volcker Rule.
The Merkley-Levin Amendment also would expand the Volcker Rule’s scope to any non-bank financial company that was deemed by the Council systemically important. Such non-banks would not be prohibited from investing in or sponsoring funds, but would need to keep such activity below certain quantitative limits (to be determined by regulation) and adhere to certain additional capital requirements (to be determined by regulation).
- Compliance Dates. Under the Dodd Bill, within 15 months of the bill’s passage, the federal banking regulators would be required to promulgate regulations to prohibit any new private equity or hedge fund investments or sponsorships. However, banks and bank-affiliates would have two years after the passage of such regulations to divest any existing investments or sponsorships (with the possibility of up to three one-year extensions). Immediately after the Dodd Bill is enacted, transactions between (i) a fund that is managed or advised by a bank or bank-affiliate and (ii) such manager/adviser or any of its affiliates would be subject to certain restrictions. For example, neither the bank nor any of its affiliates (including the affiliate that serves as manager/adviser) would be permitted to: (i) extend credit to the fund (or issue a LOC on its behalf); (ii) purchase assets from the fund; or (iii) accept the fund’s securities as collateral for an extension of credit to a third party. In addition, neither the manager/adviser nor its affiliates would be permitted to provide any services, or sell any assets to, the fund, except on market (or better) terms.
The Merkley-Levin Amendment would move up the effective date of most of the provisions of the Volcker Rule. The entire rule would take effect upon the earlier of (i) 18 months after the adoption of new federal banking regulations implementing the Volcker Rule, or (ii) 3 years after the enactment of the Dodd Bill. Accordingly, the Merkley-Levin Amendment would significantly shorten the timeframe for banks and their affiliates to cease sponsoring or investing in private equity or hedge funds and unwind their existing relationships and investments.
PRUDENTIAL RISK REGULATION
The Dodd Bill would charge the Council with monitoring and mitigating systemic risk. As part of this responsibility, the Council would have the authority to subject banks and other financial firms to regulation by the Federal Reserve Board, including strict prudential standards if the Council determines, by a 2/3 vote, that the firm poses a threat to financial stability. Factors included in that determination would include leverage, amount and nature of assets and extent and type of transactions with other financial companies. The prudential standards that would be applied might include risk-based capital requirements, leverage limits, liquidity requirements, concentration limits and enhanced public disclosures.
Senate Agriculture, Nutrition and Forestry Committee Chairman Blanche Lincoln introduced a bill governing over-the-counter derivatives (the “Lincoln Bill”), titled the “Wall Street Transparency and Accountability Act of 2010.” Because there were two bills reported out of committees—the Lincoln and Dodd Bills—the Senate Banking Committee and the Senate Agriculture Committee aimed to develop an agreement with respect to derivatives. Senators Lincoln and Dodd published a compromise bill to replace the derivatives section in the Dodd Bill (the “Compromise Bill”) which incorporated many of the Lincoln Bill's proposals.
Key Elements of the Compromise Bill:
- Dual Regulators Would Regulate Derivatives. There would be dual oversight of derivatives by the SEC and the Commodity Futures Trading Commission (the “CFTC”). Similar to the House Bill, the Compromise Bill provides that the SEC will regulate “security-based swaps” and the CFTC will regulate “swaps.” Thus, depending upon whether a derivative is a security-based swap or a swap, fund managers would be subject to the rules and regulations of the SEC or CFTC.
- Mandatory Clearing and Exchange Trading Requirements. The Compromise Bill requires that parties enter into swaps and security-based swaps through an exchange and that they clear those swaps and security-based swaps, with a few exemptions. The exemptions are limited to the following: (i) the SEC or CFTC determines that the clearing requirement should not apply; (ii) no clearing organization will accept the swap/security-based swap for clearing; or (iii) the “commercial end-user exemption” is satisfied. Financial entities, such as private funds, are not considered commercial end- users. Swaps and security-based swaps entered into before the enactment of the bill would not be subject to this clearing requirement (subject to the swap or security-based swap satisfying the reporting requirement discussed below).
- Margin Requirements. Initial and variation margin with respect to all swaps and security-based swaps will be required by the regulatory entities with certain limited exemptions that are not expected to include private funds. The amount of such margin will be determined by the entity after the enactment of the Compromise Bill. There is a commercial end-user exemption, but it does not appear that private fund managers will be exempt from the initial and variation margin requirements. The initial and variation margin requirements would apply to swaps entered into before the enactment of the bill. Non-cash collateral with respect to swaps and security-based swaps will be permitted only with the consent of the SEC and CFTC.
- Segregation of Assets Held as Collateral in Derivative Transactions. Under the Compromise Bill, uncleared swaps and security-based swaps will have different treatment with respect to collateral from cleared swaps and uncleared security-based swaps. For uncleared swaps and security-based swaps, the Compromise Bill states that dealers and major swap participants shall allow counterparties, such as private fund managers, to elect to segregate initial margin. There is no obligation to segregate variation margin. For cleared swaps, collateral for cleared swaps and security-based swaps are required to be segregated from the clearing entity.
- Mandatory Reporting Requirements. Any swap or security-based swap that is not cleared will be reported to a swap repository or, if there is no repository that would accept the swap, to the SEC or CFTC. Private investment funds that enter into a transaction with a dealer or a major swap participant (as discussed below) would not have to report the swap because the obligation to report would be the obligation of the dealer or major swap participant. With respect to a swap or security-based swap where one counterparty is a dealer and the other a major swap participant, the dealer will report the swap or security-based swap. With respect to any swap or security-based swap where neither party is a dealer or major swap participant, the counterparties will agree as to which party will report the swap or security-based swap.
- Reporting Requirements of Prior Transactions. Derivatives entered into prior to the enactment of the Compromise Bill that have not expired would have to be reported to a swap repository within 30 days after the enactment of the bill (or such other timeframe as the SEC or CFTC determines). Swaps and security-based swaps entered into prior to the enactment of the bill that would be required to be cleared pursuant to the bill are exempt from clearing if they are reported.
- Public Availability of Swap Transaction Data. Information related to a derivative, whether cleared or reported to a swap repository, will be available to the public as soon as technologically practicable after the execution of the trade. According to the Compromise Bill, the SEC and CFTC would be required to promulgate rules (i) to ensure that information does not identify participants; (ii) to specify the criteria for determining what constitutes a large notional security-based swap transaction (block trade) for particular markets and contracts; (iii) to specify the appropriate time delay for reporting large notional security-based swap transactions (block trades) to the public; and (iv) to take into account whether the public disclosure will materially reduce market liquidity. In addition, information about derivatives reported to a swap repository will be available to the public in a manner that does not disclose (i) the business transactions and market positions of any person; (ii) aggregate data on such swap or security-based swap trading volume; and (iii) positions.
- Major Swap Participants Would Be Regulated. Fund managers that are considered major swap participants will be subject to a number of requirements. They will have to register with the SEC or CFTC (as applicable). Some of the key obligations of a major swap participant are as follows: The SEC and CFTC will have reporting and recordkeeping requirements, capital requirements, and initial and variation margin requirements. Each major swap participant will have to maintain daily trading records and maintain a complete audit trail for conducting comprehensive and accurate trade reconstructions. Major swap participants will be subject to position limits. Further, the SEC or CFTC would prescribe rules to govern major swap participants, including rules that limit the activities of major swap participants. Major swap participants would be subject to business conduct requirements and conflict of interest requirements, among other obligations. The term “major swap participant” is defined as any person who is not a swap dealer, and:
- Maintains a substantial position in swaps for any of the major swap categories as determined by the SEC or CFTC, as applicable, excluding: (i) positions held for hedging or mitigating commercial risk; and (ii) positions maintained by any employee benefit plan for the primary purpose of hedging or mitigating any risk directly associated with the operation of the plan; or
- Whose outstanding swaps create substantial counterparty exposure that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or
- Is a financial entity, other than an entity predominantly engaged in providing financing for the purchase of an affiliate’s merchandise or manufactured goods, that (i) is highly leveraged relative to the amount of capital it holds; and (ii) maintains a substantial position in outstanding swaps in any major swap category, as determined by the SEC or CFTC, as applicable.
“Substantial position” will be defined by the SEC and CFTC at the threshold that the SEC or CFTC, as applicable, determines to be prudent for the effective monitoring, management and oversight of entities that are systemically important or can significantly impact the financial system of the United States. There is no definition of “highly leveraged relative to the amount of capital.”
- Prohibition Against Federal Government Bailouts of Swap Entities. There will be no federal assistance provided to any “swaps entity”1 with respect to any swap or security-based swap (including advances from any Federal Reserve credit facility, discount window, or pursuant to emergency lending authority by the Federal Reserve, Federal Deposit Insurance Corporation (“FDIC”) insurance or similar guarantees). The press has given this point particular focus because the effect of not providing federal assistance is that entities would have to segregate their derivatives trading or risk losing their status with the FDIC or the Federal Reserve.
- Additional Fiduciary Obligation of Dealers. Under the Compromise Bill, a swap dealer that provides advice regarding a swap or offers to enter into or enters into a swap with a public or private pension plan, endowment or retirement plan, will have a fiduciary duty to the public or private pension plan, endowment or retirement plan. As written, the prohibition could also extend to pooled investment vehicles in which pensions invest and that are treated as holding plan assets under ERISA, such as bank collective funds, insurance company separate accounts and plan asset look-through hedge funds. Discussions are being held to remove this provision of the bill in its entirety or to limit its application to only those situations where a pension plan is not represented in the transaction by a registered investment adviser.
- Recommendations for Changes to Portfolio Margining Laws. The SEC, the CFTC and the prudential regulators would be required to submit to the appropriate committees of Congress, 180 days after the enactment of the Compromise Bill, recommendations for legislative changes to federal laws to facilitate the portfolio margining of securities and commodity futures, options and swaps, and other financial instrument positions.
As the legislative process unfolds, we will continue keep you updated on the provisions affecting private investment fund managers.