THE CURRENT AND FUTURE STATE OF THE HEDGE FUND INDUSTRY
June 30, 2009
Nicholas S. Hodge, K&L Gates LLP
REGULATORY DEVELOPMENTS*
There have been many significant recent developments, both positive and negative:
1. New Regulatory Initiatives. There is increased concern over whether hedge funds
pose a systemic risk to our economy.
This has led to proposals to require hedge fund advisers to register under the Advisers
Act:
•
On June 16, 2009, Senator Reed introduced the Private Fund Transparency Act of
2009, which would require hedge fund advisers to register under the Advisers
Act.
•
Representative Capuano introduced a bill on January 27, 2009 that would amend
the Advisers Act to remove the Section 203(b)(3) exemption. As a result,
advisers to hedge funds would be required to register under the Advisers Act if
they had more than $30 million under management.
•
The White House White Paper Report, released on June 17, 2009, calls for all
advisers to hedge funds whose assets under management exceed a modest
threshold to register under the Advisers Act. The White Paper Report cites both
systemic risk and “a compelling investor protection rationale” for this proposal
Registration of advisers would also allow data to be collected that would enable
regulators to understand “how such funds are changing over time and whether any
such funds have become so large, leveraged, or interconnected that they require
regulation for financial stability purposes.” The White Paper Report further calls
for funds managed by SEC-registered advisers to be subject to: “recordkeeping
requirements; requirements with respect to disclosures to investors, creditors, and
counterparties, and regulatory reporting requirements.” The SEC would be
expected to share this information with the Federal Reserve, which would
determine whether the funds met the Tier 1 FHC criteria.
The concern over systemic risk has also led to proposals to require hedge funds
themselves to register under the Investment Company Act of 1940 (the “1940 Act”):
•
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In February Senators Grassley and Levin introduced The Hedge Fund
Transparency Act, S. 344, which would require hedge funds having more than
$50 million in assets under management to register under the 1940 Act but would
also exempt hedge funds from full compliance with the 1940 Act. Exemption
Summer Associate Andrea Eichman assisted in the preparation of this outline.
from full compliance with the 1940 Act would be critical, because (among other
things) hedge funds would not be able to engage in short selling and leveraging to
the extent they do now if they were subject to all of the provisions of the 1940
Act. The exemption from full compliance with the 1940 Act would be available
only if the hedge fund maintained books and records as required by the SEC and
provided information that the SEC requested.
Hedge Funds could be regulated as Tier 1 FHCs:
•
Firms whose failure could pose a threat to financial stability due to their
combination of size, leverage, and interconnectedness are called “Tier 1 FHCs” in
the White Paper Report. The Federal Reserve Board would be given the authority
and accountability for consolidated supervision and regulation of Tier 1 FHCs.
The prudential standards for Tier 1 FHCs, including capital, liquidity and risk
management standards, would be stricter and more conservative than those
applicable to firms that are not Tier 1 FHCs. The White Paper Report goes on to
say that Tier 1 FHCs that do not control insured depository institutions should be
subjected to the “full range of prudential regulations and supervisory guidance”
applicable to Bank Holding Companies.
•
Proposed Financial Services Oversight Council
•
Proposal to merge the SEC and the CFTC (probably won't happen)
2. Proposed Regulation of Short Sales. The SEC has issued proposals to impose
regulation on short sales. They were inspired in part by a perception that short sellers
had caused the rapid plummet in the value of certain stocks during the financial crisis,
especially those of financial institutions. To my knowledge, there is no empirical
evidence that this is accurate. There has been greater volatility in the stock market
since the uptick rule was abolished in 2007, but no one knows whether the abolition
of that rule has contributed to the volatility. The SEC issued five suggestions for
comment, two of them were variations on the old uptick rule, and the other three are
variations of circuit breaker rules. Comments were due by June 19 (?).
3. Proposed Regulation of the Derivatives Markets.
4. Custody. Concerns about custody of client assets have sprung from the Madoff
scandal. In the later years his firm was registered as an investment adviser under the
Investment Advisers Act of 1940 (the “Advisers Act”). It underwent an audit by the
SEC, but the fact that the assets could not be accounted for did not surface. The SEC
has proposed amendments to the custody rule under the Advisers Act (Rule 206(4)2):
•
The amendments would require registered investment advisers that have custody
of client funds or securities to undergo an annual surprise examination by an
independent public accountant to verify client funds and securities. The
accountant would be “a second pair of eyes.”
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•
In addition, unless client accounts are maintained by an independent qualified
custodian (i.e., a custodian other than the adviser or a related person), the adviser
or related person would be required to obtain a written report from an independent
public accountant that includes an opinion regarding the qualified custodian’s
controls relating to custody of client assets. The proposed amendments would
simply deem advisers whose “related persons” hold client assets to have custody
under the rule if those assets are held by the related person in connection with the
advisory services provided by the adviser.
•
Alternatively, the SEC is considering simply requiring all advisers to custody
client assets with independent qualified custodians.
•
Comments are due July 28, 2009.
[Release No. IA-2876; File No. S7-09-09]
The SEC has begun confirming adviser client account balances in connection with
routine audits of investment advisers.
5. New OCIE Initiatives. New initiatives by the Office of Compliance Inspections and
Examinations (OCIE) of the SEC were announced by Lori Richards on June 17.
These initiatives address Madoff and other recent frauds. These include:
•
Enhancing the training of OCIE examiners in fraud detection. They will sponsor
a joint training program with FINRA and NASAA in August so that examiners
will be better able to detect red and yellow flags.
•
Enhancing examiners’ expertise in complex financial products.
•
Increasing the number of OCIE examiners (currently 425 exam staff to oversee
11,000 advisers, and we can expect the number of registered advisers to increase
if advisers to hedge funds and venture capital funds are required to register).
•
Recruit professionals with specialized experience in securities trading portfolio
management, valuation, forensic accounting, derivatives, etc, and make them
“Senior Specialized Examiners.”
•
Currently conducting a sweep of firms that present certain risk characteristics,
such as advisers that custody assets with affiliates, hedge funds with smooth or
remarkable returns, and funds that have unknown auditors.
•
More information will be requested of firms prior to the commencement of the
examination so that OCIE will understand the risk characteristics before going onsite.
•
Red and yellow flags for fraud include: dominant control person, self-custody or
use of affiliate for custody; lack of independent audit; audit by obscure firm; dire
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financial condition of firm or principals; aggressive self-promotion; poor controls;
unusual activity in intercompany accounts.
•
Concern about overlap between registered and unregistered entities. This is a
common fact pattern in the hedge fund industry, where sometimes the flagship
entity is registered as an investment adviser but other entities within the
organization are not. OCIE will be looking to see whether fraudulent activity is
being concealed in unregistered entities.
•
OCIE is working to develop an off-site surveillance capacity. Advisers would be
required to submit specified information to the SEC, which would take that
information into account in determining whether an on-site examination was
warranted.
•
The SEC will improve its system for evaluating tips and complaints. As you
know, the SEC received many warnings about the Madoff situation and yet
somehow failed to act on them.
6. Enforcement Activity. There were 22 SEC enforcement actions against hedge funds
in 2008, which is a dramatic increase over prior years.
Hedge fund enforcement priorities in 2009 were identified by the SEC, FINRA,
NYSE and the New York Attorney General’s office:
•
Rumor mongering, including in the context of Credit Default Swaps. False
rumors are spread in order to affect a company’s credit quality, which can affect
trading in CDS.
•
Insider trading. SEC v. Guttenberg. Mr. Guttenberg was an executive director in
the equity research department of UBS. He illegally passed inside information
about the contents of upcoming UBS research reports to others, including a hedge
fund manager, in exchange for a portion of the illegal profits.
•
PIPE transactions
•
Portfolio Pumping (such as the purchase of a large quantity of a thinly traded
stock in order to inflate the value of the portfolio at the close of a reporting
period). Your compliance policy must address portfolio pumping.
•
Valuation/Risk of Investment
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Allocation; and
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Predatory short selling and illegal short selling in connection with Regulation M.
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7. New Opportunities. TALF funds.
8. Recent Performance of Hedge Fund Industry. In May, the Hennessee hedge fund
index posted its largest gain in nine years: 5.68%.
9. Counterparty Risk Issues. The collapse of Lehman Brothers and other major
financial institutions has led hedge funds to re-examine the risks they bear in dealing
with counterparties.
•
Hedge funds are examining the documentation relating to their derivatives to
determine what steps must be taken to manage the risks of downgrade, illiquidity,
or bankruptcy of the financial institution.
•
Hedge funds are managing the risks of their prime brokerage relationships by
entering into agreements with multiple prime brokers, understanding crosscollateralization and cross-default provisions in the documentation, and
understanding obligations to pledge, re-pledge and return collateral.
•
Funds are examining the risks they would face and the remedies that would be
available to them if financial counterparties were to become insolvent.
10. International Developments.
A. EU’s proposed Alternative Investment Fund Managers Directive, published
April 29, 2009.
1. The Directive would regulate managers of alternative investment funds
(“AIFMs”), and it outlines new requirements for the ways they should manage
alternative investment funds (“AIFs”).
a. AIFs are collective investment funds not regulated under the Undertakings
for Collective Investments in Transferable Securities Directive, such as
hedge funds.
2. Not all AIFMs would be regulated by the Directive. AIFMs with assets under
management in excess of 100 million euros who manage and/or market AIFs
in the EU need to be authorized under the proposed Directive. The 100
million euros threshold, including assets acquired through leverage, may come
from a combination of AIFs.
3. AIFMs below the 100 million euro threshold may still apply for benefits, such
as passporting, under the Directive.
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4. Proposal requires AIFMs with assets above the threshold amount to apply for
authorization. The AIFM must demonstrate its qualifications to provide
management services along with information on its planned activities, the
identity and characteristics of the AIF under its management, and its internal
rules on governance, risk management, valuation, safe-keeping of assets, as
well as audit, regulatory and reporting arrangements.
5. Even though every EU country regulates AIFMS, the EU identified this
Directive as a mechanism for addressing cross-border risks.
6. New Regulations under the proposed Directive:
a. Directive would impose a notification requirement for marketing outside
home state. AIFMs authorized in their home state are permitted to market
to professional investors in the EU, but the home state regulator would
have to provide the host state regulator with certain information about the
AIFM. EU authorized funds can passport within the EU in the same
manner, subject to the notification procedure.
b. Directive sets out rules on marketing non-EU AIFs by EU AIFMs. EUregulated AIFMs may market non-EU AIFs in the EU as long as the
country where that AIF is domiciled has an agreement under Article 26 of
the OECD Model Tax Convention with the EU member state where the
AIF will be marketed.
7. Member states could authorize non-EU AIFMs to market AIFS in the EU
subject to certain conditions:
a. The non-EU AIFM’s home country must have regulations and on-going
supervision equivalent to that required by the Directive, and the country
must grant EU-regulated AIFMs market access.
b. The non-EU AIFM must provide its home country’s regulators with
information that an EU-AIFM would be required to provide to an EU
regulator.
c. The member state and the AIFM’s home country must have a cooperation
agreement to facilitate the flow of information, and the home country must
be an OECD Article 26 compliant jurisdiction.
8. The proposal would also impose disclosure and reporting requirements on
both investors and national regulators.
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a. An AIFM using leverage above a defined threshold would have to disclose
the aggregate leverage and the main sources of leverage to its home state
regulator.
(1) The Commission announced that it would adopt implementing
measures to restrict leverage by AIFMs.
(2) National regulators would have emergency powers to restrict
leverage.
b. The Directive would impose new rules on acquisition of controlling
interests, requiring detailed disclosures to the target company and its
shareholders.
9. The proposal has received a lot of criticism, especially in the UK. The UK
fears that these new regulations would encourage fund managers to leave the
UK, especially if non-EU jurisdictions, like the U.S. and Switzerland, adopt a
less complex regulatory regime.
a. Still, the Managed Funds Association’s President applauded the proposal
as a good basis for continuing dialogue on hedge fund regulation in the
EU.
This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in
regard to any particular facts or circumstances without first consulting a lawyer.
©2009 K&L Gates LLP. All Rights Reserved.
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