In remarks at the outset of summer on financial regulatory reform, President Obama outlined general proposals for overhauling the regulation of the U.S. financial services industry, which would include requiring all private fund managers to be registered under the Investment Advisers Act of 1940, as amended (the "Advisers Act"). The Obama administration has recently proposed legislation titled Private Fund Investment Advisers Registration Act of 2009 (the "Proposed Legislation").
The Proposed Legislation would amend current Section 203(b)(3) of the Advisers Act (which provides a de minimis exception from the registration requirement for any investment adviser that has fewer than 15 clients) to require that any investment adviser to a "private fund" with at least $30 million in assets under management (including a hedge fund, private equity fund, venture capital fund or any other private pool of capital that would be an "investment company" as defined in the Investment Company Act of 1940 [the "Investment Company Act"], but for Section 3(c)(1) or 3(c)(7) of that Act), register as an investment adviser with the Securities and Exchange Commission (the "SEC"). The Proposed Legislation would exclude from the registration requirement a "foreign private adviser," which is defined to mean any investment adviser that (i) has no place of business in the U.S. and during the preceding 12 months has had fewer than 15 clients in the U.S., (ii) has assets under management attributable to clients in the United States of less than $25 million (or such higher amount as the SEC may by rule determine) and (iii) neither holds itself out generally to the public in the U.S. as an investment adviser, nor acts as an investment adviser to any U.S. registered investment company.
The Proposed Legislation would also amend Section 204 of the Advisers Act by inserting a new subsection "(b)" titled "Records and Reports of Private Funds." This new subsection would require confidential reporting by private funds of such things as assets under management, borrowings, off balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other information as determined by rulemaking which is deemed necessary to enable regulators to determine potential systemic risk and potential threats to overall U.S. financial stability. SEC examination authority would be expanded to include regular examinations of private funds in addition to the fund managers.
Finally, the SEC would have authority to share reports and other information with the Federal Reserve and with the newly proposed Financial Services Oversight Council. The information could be used to determine if a private fund or family of funds becomes so large, highly leveraged, and interconnected that it or they represent a threat to overall U.S. financial stability and, therefore, should be supervised and regulated as a Tier 1 Financial Holding Company. A Tier 1 Financial Holding Company would be subjected to stricter and more conservative prudential standards than those applicable to bank holding companies, including higher standards on capital, liquidity and risk management.
In addition to the Proposed Legislation, there are several bills pending in Congress that could require registration of private funds and/or their managers:
• Senators Charles Grassley and Carl Levin introduced on January 29, 2009, S.344 - The Hedge Fund Transparency Act, which was referred to the Senate Committee on Banking, Housing and Urban Affairs. S.344 would eliminate current Sections 3(c)(1) and 3(c)(7) of the Investment Company Act, resulting in private funds being deemed to be "investment companies" under the Investment Company Act, and replacing those sections with new Section 6 exemptions from registration. S.344 would require registration of any private fund manager, because such manager would be advising an "investment company." S.344 further proposes to require that private funds with $50 million or more in assets register with, file an information form with, maintain books and records as required by, and cooperate with any request for information or examination by, the SEC.
• Representatives Michael Capuano and Michael Castle introduced on January 27, 2009, H.R. 711 - Hedge Fund Adviser Registration Act of 2009, which was referred to the House Committee on Financial Services. H.R. 711 would eliminate subsection "(b)(3)" from Section 203 of the Advisers Act, thus eliminating any exemption from registration under the Advisers Act based on client count.
• Senator Jack Reed introduced on June 16, 2009, S.1276 - Private Fund Transparency Act of 2009, which was referred to the Senate Committee on Banking, Housing and Urban Affairs. S.1276 would limit the scope of the Section 203 exemption from registration under the Advisers Act to foreign private advisers (defined in a similar manner to the Proposed Rule), requiring private fund managers to register, and would authorize the SEC to require from private fund managers reports and records as are deemed necessary for the supervision of systemic risk by any federal department or agency.
The SEC has also endorsed legislation requiring registration of private fund managers. In testimony on July 15, 2009 before the Subcommittee on Securities, Insurance and Investment of the Senate Committee on Banking, Housing and Urban Affairs, Andrew Donohoe, director of the Division of Investment Management of the SEC, discussed regulatory approaches to private funds including (i) requiring registration of private fund managers by eliminating the exception in Section 203(b)(3) of the Advisers Act; (ii) requiring some form of registration of private funds under the Investment Company Act or imposing regulatory requirements on unregistered private funds; and (iii) providing the SEC with rule-making authority to condition the use by private funds of Sections 3(c)(1) and 3(c)(7) under the Investment Company Act. Director Donohoe further stated that direct regulation of private funds would enable the SEC to impose investment restrictions or diversification requirements, to regulate the structure of private funds (e.g., requiring an independent board of directors) and to regulate investment terms including investor redemption rights, as appropriate, to protect investors.
While it is not clear what any final legislation will look like or when legislation may be enacted, it appears likely that registration of all private fund managers will be required. Once registered, private fund managers will be subject to the disclosure requirements of the Form ADV, required to appoint a chief compliance officer, required to have in effect and maintain comprehensive written compliance procedures, including a code of ethics and procedures for addressing conflicts of interest, and subject to SEC routine examinations. It is also possible that additional disclosure may be required by private funds. We will keep you apprised of further developments in this area.
Richard Ellenbogen is a Corporate Consultant in the New York office. He engages in a general corporate practice with particular emphasis on investment adviser and investment company laws and regulations and the organization, operations and regulatory compliance of investment advisers, private equity and hedge fund managers and broker-dealers.