Updates On House Hearings On Registration Of Hedge and Private Equity Funds
Rep. Paul Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, recently introduced a discussion draft of the Private Fund Investment Advisers Registration Act of 2009 (Draft Legislation), based in large part on an earlier Treasury Department proposal.
The Draft Legislation would (i) require the registration of advisers to private funds with assets under management in excess of $30 million, (ii) narrow the "foreign private adviser" registration exemption, (iii) require the dual registration of certain commodity trading advisers, (iv) require additional record keeping and disclosure of systemic risk data, and (v) broaden the rulemaking authority of the Securities and Exchange Commission (SEC).
MFA, NVCA And PEC Spokesmen Support Legislation With Caveats
Richard Baker, President and Chief Executive Officer of the Managed Funds Association (MFA), submitted written testimony regarding the Draft Legislation to the House Committee on Financial Services on October 6, 2009. Mr. Baker reiterated the MFA's support for the general approach taken by the Draft Legislation, including the registration of advisers to private funds, although he expressed concern with respect to certain provisions, as discussed below.
Terry McGuire, Chairman of the National Venture Capital Association (NVCA) and Douglas Lowenstein, President and Chief Executive Officer of the Private Equity Council (PEC), also testified before the Committee. Mr. McGuire expressed support for the Draft Legislation, which, as set forth below, excludes venture capital funds from additional regulation. Mr. Lowenstein expressed general support for the registration of advisers, although he expressed concern with several provisions of the Draft Legislation, including the exemption of advisers to venture capital funds, which is discussed below.
The Draft Legislation would eliminate the "private adviser exemption" of Section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) and require the registration of an adviser to any private fund with assets under management in excess of $30 million. Advisers managing amounts below this threshold would remain subject to state regulation. Currently, advisers with fewer than 15 clients are generally exempt from Advisers Act registration.
Venture Capital Exemption Criticized
In contrast to the original Treasury proposal, the Draft Legislation carves out from the registration requirement any adviser to a "venture capital firm," but leaves the definition and scope of such term to the discretion of the SEC. Mr. Baker, on behalf of the MFA, and Mr. Lowenstein, on behalf of the PEC, each expressed general support for required adviser registration when assets under management exceed a certain threshold and each was critical of the venture capital exemption. Mr. Lowenstein pointed out that "venture capital funds have virtually the same business model, skill set and compensation structure [as private equity funds]," and, as a result, "it will be nearly impossible to define a 'Venture Capital' firm."
In supporting a de minimis exemption for advisers with smaller amounts of assets under management, Mr. Baker emphasized that the additional regulatory costs that result from registration "can overwhelm smaller advisers and force them out of business." Mr. McGuire, on behalf of the NVCA, expressed support for the venture capital exemption and explained that Advisers Act registration would be overly burdensome to venture capital funds, which, according to Mr. McGuire, pose little systemic risk.
Foreign Private Adviser Status
The Draft Legislation would narrow the current "foreign private adviser" registration exemption. In order to be exempt from registration, a foreign investment adviser would be required to (i) have no place of business in the United States, (ii) during the preceding 12 months have had fewer than 15 clients in the United States and assets under management attributable to such U.S. clients of less than $25 million (or such higher amount as determined by the SEC), and (iii) not hold itself out publicly as an investment adviser nor act as an investment adviser to a registered investment company. In addition, the Draft Legislation would require the dual registration of certain advisers who are registered with the Commodities Futures Trading Commission (CFTC) as commodity trading advisers (such as those who primarily, but not exclusively, trade futures). Currently, such advisers are exempt from Advisers Act registration if their "business does not consist primarily of acting as an investment adviser, as defined in Section 202(a)(11)" of the Advisers Act. Mr. Baker objected to this duplicative registration requirement, citing a lack of public policy justification.
Other Record Requirements
The Draft Legislation would impose on registered advisers new books and records requirements as well as new disclosure obligations. Registered advisers would be required to maintain and file with the SEC records and reports detailing (i) the amount of assets of under management, (ii) the use of leverage (including off-balance-sheet leverage), (iii) counterparty credit risk exposures, (iv) trading and investment positions, (v) trading practices, and (vi) such other information as the SEC in consultation with the Federal Reserve determines to be necessary or appropriate.
In addition, registered advisers would be required to provide to investors, prospective investors, counterparties, and creditors certain reports, records and other documents of any private fund managed by the investment adviser, as the SEC determines to be necessary or appropriate. Finally, the Draft Legislation would impose additional record-keeping requirements on registered private fund advisers but leaves the specific requirements for the SEC to formulate. Any information disclosed to the SEC would generally be treated as confidential to the extent permitted by law.
Objections To Some Disclosures
On behalf of the MFA, Mr. Baker did not oppose the additional disclosure required to be filed with regulators, but did request clarity on the requirement, particularly with respect to the disclosure of "trading practices," which remains undefined. Mr. Baker expressed concern with the provision requiring additional disclosure to counterparties and creditors where he sees a disconnect between such disclosure and the priorities of investor protection and systemic risk mitigation. He suggested that disclosure from counterparties' or creditors' clients would not provide the type of information necessary to adequately assess systemic risk concerns, and, in lieu of such requirement, proposed the imposition of standards on those who extend credit. He suggested that, at a minimum, counterparty disclosure should be bilateral, and proprietary trading strategies and algorithms should be protected from disclosure to other market participants.
Mr. Lowenstein, on behalf of the PEC, expressed similar concerns regarding the requirement of additional disclosure to counterparties and creditors, stating that such third parties "are all highly sophisticated market participants with the leverage to bargain with the fundto obtain whatever information they believe necessary to evaluate the contract, relationship or credit." Mr. Lowenstein also criticized the provision of the Draft Legislation that would grant the SEC broad authority to require additional reporting as "sweeping and troublesome."
The Draft Legislation would grant the SEC broad authority to craft additional regulations and suggests the SEC classify registered advisers according to their size, scope, business model, compensation scheme, and potential to create systemic risk and impose differing regulations based on such classifications. In addition, the Draft Legislation would grant the SEC authority to "ascribe different meanings to terms (including the term 'client') used in different sections as the [SEC] determines necessary." Redefining the term "client" in a manner that would look through funds to their individual investors would, according to Mr. Baker, impose fiduciary obligations on advisers with respect to each fund investor. He suggested such duties would lead to potential conflicts of interest between an adviser's obligation to the fund and to its investors, and further stated that an adviser to a pooled vehicle would likely lack sufficient investor-level information to determine whether an investment by such vehicle is suitable for each investor.
Mr. Baker, on behalf of the MFA, recommended additional measures aimed at investor protection including (i) increasing the "qualified client" threshold from $1.5 million to $2.5 million and indexing it for inflation, (ii) requiring an annual audit for each private fund managed by a registered adviser with custody of client assets, (iii) enhancing the Form ADV with additional information regarding an adviser's key service providers, and (iv) automatically barring persons who have engaged in prior criminal behavior while associated with a broker, dealer or investment adviser from being associated with any other securities industry participant. Mr. McGuire, on behalf of the NVCA, proposed that venture capital funds be required to provide additional systemic risk data as a supplement to the Form D, which such funds already file with the SEC in connection with their securities offerings.
The Discussion Draft is currently under consideration by the House Committee. We will continue to monitor the progress of this and other proposed legislation impacting private investment funds and their managers.
R. Scott Beach is the Co-leader of the Private Equity and Investment Funds practice group. He represents private equity investors and emerging growth companies in formation, debt and equity financing, mergers and acquisitions, strategic joint ventures, technology arrangements and general corporate matters. Gregory D. Shalette is an Associate in the firm's Private Equity and Investment funds practice group.