The Obama Administration is proposing legislation that will remove the exemptions from registration enjoyed by managers of private investment partnerships and hedge funds. The legislation will require the registration of virtually all investment advisors who operate from the United States, or who provide services to United States citizens, and who manage over $25 million in assets.
Hedge fund managers and those who manage private investment partnerships need to pay careful attention to this new legislation. Not only will this legislation require the registration of thousands of unregistered investment advisers, it will impose new recordkeeping and reporting requirements on all managers of hedge funds and private investment partnerships.
New Registration Requirements
The legislation requires registration of any adviser who is based in the United States, or whose clients are based in the United States, representing a dramatic change in the registration and regulation landscape for investment advisors. If adopted, the legislation would eliminate the exemption currently used by such advisers. Under current rules, advisers who have less than $25 million dollars under management are exempt from federal registration, as are advisors who have less than 15 clients. Most managers of private investment partnerships have only one or two clients their funds and are therefore exempt from registration at the federal and state level.
The new regulations will remove that exemption, and will require the registration of any investment adviser to a “private fund.” The legislation defines a “private fund” as an investment fund that (A) would be an investment company (as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3)), but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) or 80a-3(c)(7)); and (B) either(i) is organized or otherwise created under the laws of the United States or of a State; or (ii) has 10 percent or more of its outstanding securities owned by U.S. persons.
Translating that into English, a private fund is an entity which is engaged primarily in the business of investing, reinvesting, or trading in securities; otherwise known as a hedge fund, or a private investment partnership.
While this is clearly a reaction to the Madoff scandal, most readers will recall the SECs failed attempt in 2005 to register hedge fund advisors. The SEC attempted to register such advisers by using its rule making power. The SECs rule, which became effective in February 2005, was known as the Hedge Fund Rule, and was adopted under the Investment Advisers Act of 1940, 15 U.S.C. 80b-1.
The original rule was adopted on questionable factual grounds, and there was a significant dissent to the adoption of the rule from two of the five SEC Commissioners My commentary on the rule discussed the potential problems with the enactment, and entire rationale for the rule. See, Registration of Hedge Fund Managers -Bureaucracy Without Benefit.
In 2006 the United States Court of Appeals for the DC Circuit struck the SECs controversial rule. I discussed the reversal in a previous article, Court Strikes New Hedge Fund Rule
This time around, Congress is amending the Investment Advisers Act of 1940, which presumably will address the technical issues that the Court had with the Hedge Fund Rule, but the problems with such a rule will remain. No one has addressed the question of how the SEC, which is under-funded and under-staffed is going to be able to monitor and regulate these new registrants. It has been painfully obvious to those of us practicing in this arena that the SEC cannot carry out its mandate as currently constituted. There has been no discussion as to how it is going to handle these additional responsibilities.
Implication for Investment Advisers
The new rule will not affect investment advisers who manage less than $25 million in assets, as registration of those advisers has been delegated to the states. However, any adviser who manages over $25 million dollars will have to register with the Commission, regardless of the size of its assets under management. Registration of a federal investment advisory firm is not a simple task, and comes with a complete set of rules, regulations and compliance standards. We have addressed those requirements in another release, Registration and Regulation of Investment Advisers.
Recordkeeping and Retention Rules
Congress is also adding new record keeping requirements. Congress is attempting to require advisers to private funds to maintain records and to submit reports relating to its operations and the operation of the private fund. While the language in the proposed bill requires some tweaking, as it is incorrect, questions remain as to whether Congress and the Commission can deem the records of a private fund to be the records of the investment advisor.
Assuming that Congress will correct the text, and will address the constitutional issue with the reporting requirements, the legislation will require advisers to report, at a minimum, the amount of assets under management, use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading investment positions, and trading practices. Congress is also granting the SEC the authority to require additional reports and information, after consultation with Board of Governors of the Federal Reserve System.
The legislation also allows the Commission to require advisers to provide such information and reports to investors, prospective investors, counterparties, and creditors, of any private fund, which should make for an interesting series of problems and issues with respect to confidentiality and the disclosure of proprietary trading and investment strategies.
Issues to be addressed
The adoption of this legislation will require numerous hedge fund and private investment partnership investment managers to register with the SEC and to subject themselves to the registration and reporting requirements of the new Investment Advisers Act of 1940. Currently registered advisers to such entities will be subjected to the new reporting requirements, and will require new systems and reports to be developed to comply with the new regulations.
Existing advisers who manage less than $25 million in assets are not effected under the current proposal. However, we expect to see the adoption of similar rules by the state securities regulators, which would apply to advisers who are currently exempt under the blue sky laws of most states.
Private fund managers need to keep a careful eye on this legislation, and should plan to register, and to comply with the new regulations once enacted.
Our attorneys, and those in our national network, are experienced securities and compliance attorneys, and include former SEC and NASD enforcement attorneys. We are available to assist you in addressing any questions you may have regarding these issues. Please contact Mark J. Astarita, at x 121 or email@example.com or