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.