Brave New World: The Future of Hedge Fund Registration

The latest casualty of the extreme market dislocation and subsequent “bailout” of financial institutions appears to be the “private fund” exemptions which allowed both hedge and private equity funds to avoid SEC registration under the Investment Company Act of 1940 (“the Company Act”). Under current law, pooled investment vehicles with fewer than 100 investors (Section 3(c)(1) of the Company Act) or whose investors are all qualified; that is, they own not less than $5 million in investments (Section 3(c)(7) of the Company Act), are excluded from the definition of “Investment Company” and therefore from all the requirements, including registration, of that Act so long as interests therein are sold in accordance with the private offering rules under the Securities Act of 1933 (“the Securities Act”).

Concern that the popularity of these structures had given rise to a vast universe of unregulated financial influence drove the SEC back in 2005 to amend the “private advisor” exemption under the Investment Advisers Act of 1940 (“the Advisers Act”) to require most hedge fund managers to register. Though that requirement became effective on February 1, 2006, the SEC’s approach of amending terms in some parts of its rules and not others (notably, changing the definition of “client” to require a look-through only for counting how many clients existed for registration) made it vulnerable to attack, and the D.C. Circuit Court of Appeals invalidated the SEC’s actions in June 2006 in Goldstein v. Securities and Exchange Commission.

There’s nothing like economic turmoil to forge political will, and Congress has been actively considering measures both to reverse Goldstein and to require that private market participants provide more information to regulators and subject themselves to regular inspection.

The most widely discussed (and viewed as likely to be enacted) proposed legislation is the “Hedge Fund Transparency Act” sponsored by Senators Charles Grassley (R-Iowa) and Carl Levin (D-Michigan). The Hedge Fund Transparency Act would do away with the 3(c)(1) and 3(c)(7) exemptions from registration, but move the language in those sections to another part of the Act so that investment vehicles with those types of investors would be exempted from most of the substantive provisions of the Company Act. Private funds with more than $50,000,000 in assets under management would have to register, but rather than filing a prospectus would have to file an annual Information Statement with the SEC. Though the precise contours of that form would be determined by the SEC, the proposed legislation suggests that the filing fund would need to disclose:

*The name and address of every investor in the fund;
*The name of the outside auditors and prime broker;
*A description of the fund ownership structure;
*Any affiliations with other financial institutions;
*The current value of the funds assets; and
*The total number of investors.

Of course there are many unresolved questions here, including but not limited to whether there will be a look-through for identification purposes, whether any portion of the report can be filed confidentially, whether the scope of the requirement will capture more than just private equity and hedge funds but also joint ventures and SPVs, and whether one filing would be required for each fund (that is, each master or feeder) or whether some combination form might be submitted.

The registrant would also be subject to certain record-keeping requirements, and of course, presumably be subject to SEC inspection. If enacted, there would be a 180 day implementation period to allow registrants to gather the necessary information.

But hedge funds won’t be alone, because advisers will probably have to register also. The Hedge Fund Adviser Registration Act of 2009, introduced by Representatives Michael Capuano (D-MA) and Michael Castle (R-DE), would eliminate the "private adviser" exemption presently set forth in Section 203(b)(3) of the Investment Advisers Act of 1940 that the SEC tried to finesse in Goldstein. This will require that any adviser, no matter how few clients are serviced, will be subject to registration. This means filing an ADV no less than annually, becoming subject to Codes of Ethics, annual compliance reviews, books and records requirements and more.

Nothing is final, of course, and these bills will have substantial comment prior to enactment. But it would be foolish to assume that either one will simply disappear. Registration for hedge funds and their advisers is on the horizon. We’ll keep up with developments for you and let you know how we can help you meet any new requirements.

Sutro at SIFMA-CL (Day 3)

SOME ARE CALLING PRIVACY AND THE SOON TO BE AMENDED REG S-P “THE NEW AML” FOR BROKER-DEALERS


In March 2008, in response to increasing identity theft and concern for protection of customer privacy, the SEC announced significant proposed changes to Reg S-P. (SEC Notice). Comments on the proposed rules are due to the Commission by May 12, 2008. Many senior legal and compliance professionals attending the SIFMA CL Conference in Orlando, Florida compared the requirements of proposed Regulation S-P to the rigors of AML compliance. If adopted as proposed, the new privacy rules will present significant financial and administrative burdens to broker-dealers.

The proposed rules broaden the definition of non-public customer information and set forth stricter standards for handling, protecting, disposing and sharing customer information. The rules require regular privacy risk assessments and stricter identification and management of potential threats and vulnerabilities. They also set forth a road map for notifying customers of any actual or potential privacy breaches.

The Reg S-P amendments also include a new exception that will allow registered representatives or advisors moving from one financial services firm to a new firm to take certain limited customer information. This exemption appears to mirror the terms of the Broker Protocol which has been in place between and among numerous financial services firms for some time.

Sutro at SIFMA-CL (Day 2)

SALES TO SENIORS IS EMPHASIZED AT ANNUAL SIFMA CL CONFERENCE

Sales to Seniors is unquestionably the hot topic at the 40th Annual SIFMA CL Conference in Orlando. FINRA, the SEC, compliance professionals, in-house and outside counsel are highlighting and stressing the need for firms to focus on the propriety of their sales practices and adequacy of their supervisory procedures related to marketing, selling and communicating with senior clients.

The regulators remind the industry that there are no special rules for seniors. Rather, suitability standards, the firm’s sales and marketing policies and the firm’s written supervisory procedures should encompass all issues related to sales to seniors (FINRA Notice).

Some considerations when serving senior clients include:

· age
· life stage
· liquidity needs
· retirement plans
· diminished capacity
· heirs, fiduciaries and estate planning issues
· client sophistication and suitability of product
· commission versus fee-based arrangements

Firms should be surveying, testing and validating their supervisory policies and procedures to assure protection of senior clients. Firms should be training their sales forces and adopting best practices related to sales to seniors.

Sutro at SIFMA-CL (Day 2)

SEC ANNOUNCES 11 AREAS OF SCRUTINY FOR THEIR 2008 BROKER DEALER EXAMS


At the SIFMA CL General Session, the SEC announced eleven areas of scrutiny for their 2008 Broker/Dealer examinations:

1. Valuations.
2. Adequacy of firm internal controls over material non-public information, including written supervisory policies and procedures and testing.
3. Retail sales practices. Particular focus on sales to seniors (SEC Report), suitability of sales of CMO’s, structured products, limited partnerships, REITS and other alternative investments.
4. Supervision. Particular focus on any unsupervised firm activities, any failure to implement and test written supervisory procedures and on the adequacy of supervision of “independent brokers”.
5. Given current market conditions, the SEC will be looking at net capital and the firm’s internal controls around the calculation of net capital.
6. Trading issues. Particular focus on best execution and Reg SHO compliance.
7. Fixed Income. Particular focus on pricing, mark-ups, suitability, CMOs, asset-backs, and G-37 “Pay to Play” compliance.
8. Rating agency scrutiny.
9. Conflicts of Interest. Particular focus on whether Advisors are paying to be on a preferred B/D recommended list and whether firms are recommending securities in which the firm has a financial or ownership interest.
10. AML. Particular focus on adequacy of independent testing.
11. Information and account security. Particular focus on Reg S-P controls to protect customer information. Particular focus on outside vendor outsourcing and the vendor’s protection of non-public customer information.

Sutro at SIFMA-CL

At the opening General Session of the 40^th Annual SIFMA Compliance and Legal Conference in Orlando, Florida, Mary Shapiro, CEO of FINRA, and Richard Ketchum, EVP of NYSE, reported that the recent merger of the Member Regulation function of the NYSE and NASD and its re-composition as the Financial Industry Regulatory Authority (“FINRA”) is proceeding well, meeting deadlines and generally exceeding expectations.

Ms. Shapiro described the merger process as falling into four buckets:
1) Governance (almost complete);
2) Business Processes including Enforcement, Risk Assessment and Dispute Resolution (in process);
3) Technology (expect technology harmonization to be complete by mid-2009); and
4) Rulebook (expect proposed conduct rules for comment by the Spring of 2008)

The greatest challenge presented by the merger is the creation of the FINRA rulebook. FINRA is taking the opportunity to take a fresh look at all of the rules rather than merely choosing between an existing NYSE or NASD rule. Where possible, FINRA is looking at opportunities to simplify rules and, if appropriate, to apply a principles-based outcome-oriented approach to their rule making. In a recent Information Notice, FINRA describes their rule consolidation process and discusses what rules are and are not susceptible to a more principles-based approach.

There was an interesting discussion and a lively debate about the benefits and challenges of principles-based regulation. Regulators observed that some aspects of the recent financial markets crisis seem to call out for rules-based solutions. Although there was a slight hint of regulatory skepticism of the practicality of a move toward more principles-based rules, the regulators unequivocally acknowledged that principles have an important role in understanding ethical issues, clarifying regulatory goals, and improving communication between the industry and the SRO’s. Clearly, the principles-based issue will be a hot topic for some time.