In events that could have significant impact on investment advisers, yesterday U.S. Securities and Exchange Commission (SEC) Chairwoman Mary Schapiro testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs (Senate Banking Committee) on proposals to enhance investor protection and regulation of the securities markets, and U.S. Treasury Secretary Timothy Geithner outlined a “Framework for Regulatory Reform” before the House Committee on Financial Services. The SEC Chairwoman testified that the SEC is considering requiring investment advisers to hedge funds to register under the Investment Advisers Act of 1940, as well as the registration of hedge funds. She also stated that the SEC is studying whether broker-dealers and investment advisers should be subject to the same regulatory regime and indicated that the custody rule for investment advisers is under consideration for significant revisions. The Treasury Department’s proposed framework for regulatory reform calls for, among other things, certain hedge fund advisers (as well as advisers to other pools of capital) to register with the SEC and provide investor and counterparty disclosure and reports to the SEC. These developments are discussed in more detail below.  

SEC Chairwoman Testimony

Hedge Fund and Hedge Fund Adviser Regulation  

The Chairwoman stated that the SEC is considering asking Congress for legislation that would require registration of investment advisers that advise hedge funds, and possibly the hedge funds themselves. Such laws, if enacted, would likely subject hedge fund advisers to the SEC’s examination authority and lay the groundwork for future rule-making. She also suggested requiring the individual hedge funds themselves to register, which would give the SEC deeper insight into such funds.  

Chairwoman Schapiro had previously testified to the Senate Banking Committee at her nomination hearing that she would consider resurrecting the registration rule, which was vacated by a federal court in 2006. At that time, she said that requiring hedge fund advisers to show their books to regulators will give the SEC a better handle on “who is out there and what they are doing.” (In 2005, the SEC adopted amendments to rules that effectively required hedge fund advisers to register under the Investment Advisers Act of 1940. Hedge fund manager Phil Goldstein challenged the rule in court, arguing the SEC exceeded its rule-making authority to regulate advisers that managed a limited number of funds. The U.S. Court of Appeals for the District of Columbia Circuit agreed, vacating the rule in 2006. Nevertheless, it has been reported that about a fifth of all hedge fund advisers remain registered with the SEC.)  

Broker-Dealer/Investment Adviser Regulation

Chairwoman Schapiro also stated that the SEC is studying whether to recommend legislation “to break down the statutory barriers that require a different regulatory regime for investment advisers and broker-dealers” on the basis that the services they provide often are identical from investors’ perspective. Although not referenced in her testimony, one would expect that consideration of this proposal is in part the result of the SEC’s review and consideration of the Rand Report on Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, which was conducted in 2007 to examine investment advisers’ and broker-dealers’ marketing practices and to evaluate investors’ understanding of the differences between the two types of firms. The Chairwoman’s testimony and oral statements to the Committee increase the chance that Congress will create a single category of financial intermediary under the federal securities laws that can provide a panoply of products and services that are currently available under the broker-dealer and investment adviser regulatory structures.  


Chairwoman Schapiro also testified that she has asked the SEC staff to prepare a proposal that would require investment advisers with custody of client assets to undergo an annual third-party audit, on an unannounced basis, to confirm the safekeeping of client assets. In addition, she indicated that the staff would likely recommend proposing a rule that would require certain advisers to have third-party compliance audits to review their compliance with the law.  

To ensure that all broker-dealers and investment advisers with custody of client funds carefully review controls for the safekeeping of those assets, the SEC staff also is likely to recommend, according to the Chairwoman, that the SEC consider requiring a senior officer from each firm to attest to the sufficiency of the controls they have in place to protect client assets.  

Chairwoman Schapiro also noted that the list of certifying firms would be publicly available on the SEC’s Web site so that investors can check on their financial intermediary. In addition, the name of any auditor of the firm would be listed, which would provide investors and regulators with information to evaluate the auditors.  

Treasury Proposal

Hedge Fund and Hedge Fund Adviser Regulation  

Treasury Secretary Geithner, as part of the proposed regulatory reform package, asked Congress to enact laws requiring hedge funds to register with the SEC. Under his proposal, any hedge fund meeting a certain asset size would have to register with the SEC.

Secretary Geithner cited the Bernard Madoff scandal as proof of the need for increased hedge-fund supervision. He also noted systemic risk concerns. Currently estimated at greater than $1 trillion in size, the hedge fund industry has a symbiotic relationship with the banking sector, providing an attractive outlet for bank capital, investment management services for banking clients, and fees for brokerage services, credit and other banking functions. As a result, the Treasury Department believes that the risk exposures of the hedge fund industry may have a material impact on the banking sector, resulting in new sources of systemic risks.

The Senate has already begun to consider hedge fund registration. In January 2009, Senator Carl Levin (Michigan) and Senator Charles Grassley (Iowa) introduced the “Hedge Fund Transparency Act.” As proposed by the bill, hedge funds with assets of $50 million or more would have to register with the SEC. Also, the hedge fund would have to make available the names of each natural person who is a beneficial owner of the hedge fund. The hedge fund would have to prepare a disclosure document that among other things disclosed the size of the fund and the name of its prime brokers.

Next Steps

It is likely that various Congressional bills and legislative and rulemaking proposals from the SEC and the Treasury Department will be considered in the coming months. While it is unlikely that all of these proposals will result in legislative or regulatory reform, it is clear that the pace of reform has picked up and that there is political willpower to significantly reform the regulation of financial intermediaries under the federal securities laws.