(The article featured
below is a selection from Hedge
Funds and Private Equity: Risk Management and Regulatory Update, which is
available to subscribers of that publication.)
Industry Supports Draft Legislation
Regulating Advisers to Hedge and Private Equity Funds
The
hedge fund industry generally supports draft legislation in the House Financial
Services Committee requiring advisers to hedge funds and private equity funds to
register with the SEC. Vetted by Rep. Paul Kanjorski, Chair of the Capital
Markets Subcommittee, the Private Fund Investment Advisers Registration Act
would mandate the registration of private advisers to hedge funds and other
private pools of capital and impose new recordkeeping and disclosure
requirements on private advisers in order to provide regulators the information
they need to evaluate both individual firms and entire market segments.
In testimony before the committee, Richard Baker, CEO of the
Managed Funds Association, said that applying the registration requirement to
currently unregistered investment advisers to all private pools of capital,
instead of just hedge fund managers, is a smart approach to this type of reform.
Removing the current exemption from registration for advisers with fewer than
fifteen clients would be an effective way to achieve this result. Further, the
MFA believes that the Investment Advisers Act provides a meaningful regulatory
regime for registered investment advisers. The responsibilities imposed by the
Advisers Act are not taken lightly and entail significant disclosure and
compliance requirements.
The MFA urges Congress to include a narrowly tailored de
minimis exemption from registration for the smallest investment advisers that
balances the goal of a comprehensive registration framework with the economic
realities of small investment advisers. Regulatory resources, capabilities and
structure should also be considered as policy makers determine an appropriate de
minimis threshold. Congress should also ensure that any approach in this
regard is consistent with state regulation of smaller investment advisers and
avoids duplication.
While the MFA declined to propose a specific de minimis
amount, Mr. Baker encouraged Congress to determine an amount that is not so high
as to create a significant loophole that undermines a comprehensive registration
regime, and not so low that the smallest investment advisers are unable to
survive because of regulatory costs.
The MFA also cautioned that legislation should not impose
limitations on the investment strategies of private pools of capital. As such,
regulatory rules on capital requirements, use of leverage, and similar types of
restrictions on the funds should not be considered as part of a regulatory
framework for private pools of capital.
It is critical that regulators keep confidential any
sensitive, proprietary information that market participants report. Public
disclosure of such information can be harmful to members of the public that may
act on incomplete data, said the MFA, and could harm the ability of market
participants to establish and exit from investment positions in an economically
viable manner. Regulations should not force market participants publicly to
reveal information that would be tantamount to revealing their trade secrets to
competitors.
Similarly, the SEC should share reported information with
foreign regulators only under circumstances that protects the confidentiality of
that information. For example, the SEC has adopted Exchange Act Rule 24c-1
allowing the Commission in its discretion to share nonpublic information with a
foreign financial authority if the authority receiving the information provides
assurances of confidentiality as the Commission deems appropriate. The MFA urged
the SEC and other U.S. regulators to employ this type of approach when sharing
information with foreign regulators.
The MFA also urged Congress to construct the new regulatory
regime in a way that distinguishes between different types of market
participants and different types of investors or customers to whom services or
products are marketed. One notable distinction that should be retained is
between private sales of hedge funds to sophisticated investors under the
SEC’s private placement regime and publicly offered sales to retail investors.
This distinction has been in existence in the United States for over 75 years,
noted the MFA CEO, and has proven to be a successful framework for financial
regulation. The MFA strongly believes that regulation that is appropriate for
products sold publicly to retail investors is not necessarily appropriate for
products sold privately to only sophisticated investors.
A specific concern of the MFA is the elimination of the
current exemption from SEC registration in Section 203(b)(6) of the Advisers
Act, for commodity trading advisors registered with the CFTC. This change would
create unnecessary, duplicative and costly requirements for those advisors.
This is a limited exemption for commodity trading advisors
for CFTC registered advisors who do not primarily act as an investment adviser.
This exemption does not create a regulatory gap, said the MFA, nor does it leave
advisers to private funds outside of a registration framework. Rather, it
ensures that CTAs to private funds, which are primarily engaged in the business
of providing advice regarding futures and are already subject to comprehensive
regulation do not have to be subjected to a dual registration and regulatory
framework.
The MFA is also concerned that the delegation of authority
to the SEC to define the term “client” is overly broad. There is concern
with respect to an adviser’s fiduciary obligations to its clients,
specifically with imposing fiduciary obligations on an adviser with respect to
investors in pooled investment funds managed by that adviser.
An adviser to a pooled investment fund likely would not have
the information about the underlying investors in the fund necessary to be able
to determine whether an individual investment made for a fund’s portfolio
would also be appropriate for an individual investor. Further, applying
fiduciary obligations to the investor and the fund can create potential
conflicts between an adviser’s obligations to the fund and obligations to
investor.
There is further concern about imposing disclosure to
counterparties on private fund managers that do not apply to any other financial
institutions. It is unclear to the MFA how disclosure from a private fund
adviser to its counterparties raises either investor protection or systemic risk
concerns. Counterparties are not investors, emphasized Mr. Baker, they are
sophisticated market participants capable of protecting their own interests in
negotiating a transaction.
There must also be some limitations on the types of
information that an investment adviser should be required to disclose to other
market participants. For example, the MFA would oppose a requirement that
broadly forces an investment adviser to reveal its proprietary trading
strategies or algorithms.
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