Category Archives: new hedge fund regulations

MFA Supports Hedge Fund Registration

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MFA Lobbyist Testifies to Congress Regarding Hedge Fund Registration

In a somewhat surprising move, the MFA stated to Congress today that it supports registration for hedge fund managers.  Below is a press release regarding the statement.  The MFA also released its final written testimony to Congress which can be found here. CNBC has also produced a short news clip on this event which can be found here (note: you may have to watch a commercial for pajamagram).

I will continue reporting more on this issue and will also update this post once I have had a chance to review the written testimony.
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News Release
FOR IMMEDIATE RELEASE CONTACT:
Meg Bode
(516) 869-6610

May 7, 2009

MANAGED FUNDS ASSOCIATION ANNOUNCES SUPPORT FOR REGISTRATION OF INVESTMENT ADVISERS INCLUDING HEDGE FUNDS

WASHINGTON, DC – In testimony before the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises hearing, “Perspectives on Hedge Fund Registration,” Managed Funds Association (MFA) today announced its support for mandatory registration with the Securities and Exchange Commission (SEC), of investment advisers, including advisers to private pools of capital under the Investment Advisers Act of 1940.

Richard H. Baker, MFA President and CEO, said, “Though hedge funds were not the cause of the ongoing problems in our financial markets and our economy, MFA and our members share the commitment of policy makers to enact measures that will help restore stability to our markets, strengthen financial institutions and restore investor confidence. We believe supporting mandatory registration for investment advisers is just one of the many important steps that can be taken towards these mutually shared goals.

Baker noted, “This proposed framework goes beyond that recently called for by Treasury Secretary Geithner. The Administration’s proposal called for only the largest fund advisers to be registered for the purpose of assessing their systemic relevance. The registration regime we are supporting today, which has been driven largely by changes in markets and the growing demands of investors, is more comprehensive and will subject the vast majority of investment advisers, including the largest and those considered most systemically relevant, to the SEC’s registration requirements.

Baker’s testimony stressed that while hedge funds are important to the capital markets and the financial system, the relatively small size and scope of the industry, with approximately $1.5 trillion in assets under management, did not pose significant systemic risk. He also stressed that hedge funds are substantially less leveraged than banks, have outperformed the overall market and have not sought any federal assistance.

Baker indicated that to fulfill these additional responsibilities, without diminishing the agency’s ability to meet its core mission of investor protection, the SEC would need additional resources specifically for personnel, technology and training and recruitment.

“A registration framework that overwhelms the resources, technology and capabilities of regulators will not achieve the intended objective, and will greatly impair the ability of the regulator to fulfill their existing responsibilities, as well as their new responsibilities.”

In addition to supporting registration, MFA’s written testimony outlined several key principles that they believe Congress, the Administration and other policy makers should consider as they discuss changes to the financial regulatory system.

A copy of MFA’s written testimony is available at www.managedfunds.org.

About Managed Funds Association

MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York. For more information, please visit: www.managedfunds.org.

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Bay Area Hedge Fund Roundtable Event

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Panel Discussion on State of Hedge Fund Industry

Yesterday afternoon (May 6th) the Bay Area Hedge Fund Roundtable, a group of professionals within the hedge fund industry, gathered for a panel presentation entitled “Change…Critical Legal, Tax, Acounting and Regulatory Updates You Need to Know.”  The presentation was moderated by Pamela S. Nichter (Osterweis Capital Management) and included the following panel participants:

Vincent J. Calcagno (Rothstein Kass)
Geoffrey Haynes (Shartsis Friese)
Tony Hassan (Ernst & Young)
Anita K. Krug (Howard Rice)

Presentations like these are great because they allow professionals to share insights into what is going on in different parts of the industry – many of the topics discussed allowed the panelists to really dig deep into the issues and provide some context to what is happening at both the regulatory and investor levels.  I took notes during the presentation and will summarize some of the main points discussed by each of the presenters (please don’t hold anything against the speakers if I mis-paraphrase or mis-interpret and as always nothing in this summary is tax or legal advice)…

Anita K. Krug

Anita discussed a number of the laws which have been discussed or proposed over the past 6 to 8 months including the following:

  • Barney Frank’s Recent Comments (see Reuters article)
  • Mary Shapiro’s Recent Comments (see Bloomberg article where Shapiro says she wants the ability to make rules regulating hedge funds)
  • Discussion of the Hedge Fund Transparency Act which was proposed in the Senate earlier this year (see also Overview of the Hedge Fund Transparency Act)
  • Hedge Fund Advisor Registration Act which was proposed in the House earlier this year
  • Geithner’s hedge fund proposals (see NY Times article for background information)
  • Discussion of the past short selling rules (see HFLB article) and the new short selling rules which will be closer to the old “uptick” rule (see SEC overview; note: I have not yet had an opportunity to thoroughly review these proposed rules)
  • European Rules which have been proposed which may have an effect on US based managers with EU investors (Anita raised many of the same issues which were also raised in this article)

Geoffrey Haynes and Vincent J. Calcagno

Geoffrey and Vincent went back and forth discussing some of the tax issues which managers are likely to face this year and potentially going forward.  This discussion included the following issues:

  • Discussion of the new offshore deferral rules by dint of new Section 457A of the Internal Revenue Code (see generally this alert).  Note: discussions on the ramifications of this new section to managers who currently have deferral arrangements took a majority of the time.  There are a number of issues involved including issues with side pockets, options, and non-conventional performance fee periods.
  • San Francisco Payroll Tax of 1.5% (see background on this issue here)
  • Discussion of the Levin proposal to tax the carried interest as ordinary income (see Hedge Fund Carried Tax Increase?).  [The panelists seemed to think that Congress would not vote on this bill until sometime in 2010 (if the bill was actually even voted on) with an effective date, if passed, of sometime in 2010 – the panelists did not seem to think it would be retroactively applied.]
  • Discussion of a bill which would eliminate UBTI for U.S. based non-taxable investors investing in U.S. hedge funds which utilize leverage (note: I was not aware of this bill and am not sure what bill exactly was referred to – please feel free to contact me if you know about this bill).  The panelists seemed to think this bill was likely DOA.
  • Discussion of the Stop Tax Haven Abuse Bill by Senator Levin (see Senator Levin’s press release)
  • Discussion of Obama’s Offshore Tax Plan (see generally the White House press release)

Tony Hassan

Tony discusses what is changing in the area of hedge fund operations.  Tony’s discussion of current topics was maybe one of the more important parts of the panel in terms of providing insight on current investing trends and due diligence requests.  Many of the items in this section were part of a dialogue between Tony and Vince as noted in the parenthesis below.

  • There is no secret that due diligence is a more central and important part of the investing process than it was previously.  (Tony and Vince)
  • Due diligence is also changing in many respects – at E&Y Tony has had specific requests from potential invests to send them directly the financial statements.  Of course this brings up many legal and client issues (the hedge fund, not the potential investor, is the client of E&Y) and because of this these requests are often denied. (Vince)
  • Managers are providing verified transparency “quarterly reviews” which aim to show investors that the fund’s assets are actually there.  (Vince)
  • Some funds are instituting a half-yearly audit (in addition to the end of year audit).  (Vince)
  • Some funds are instituting agreed upon procedure reports.  In these reports the auditor will come in an verify that certain procedures are being completed.  This may be especially important with regard to the valuation of the fund’s assets.  (Vince)
  • Tony noted that this is really a new form of due diligence and used the term “Hedge Fund Due Diligence 2.0” – a term I used in October of 2008 (see post).
  • Investor questions to hedge funds are changing.  While previous questions would have stopped after “Do you have a 3rd party administrator?”  Now the questioning continues – investors want to know about the administrators technical expertise, who exactly will be the account representative and what type of capital markets experience does that person or group have, what inputs will be used to value assets, etc.  Investors also want to know what sort of contingency plan is in place should the administrator fail or if there is a disaster; investors will want to know if the fund is keeping shadow books.  (Tony)
  • Tony also participated in the discussion with Pamela below with regard to managed accounts.

Pamela S. Nichter

Pamela, the moderator of the discussion, also weighted in on certain operational issues which fund managers should be prepared for in the new climate.  In general Ms. Nichter is seeing more investor requests and communications.  Now there is greater communication between the investor and the fund manager.  Ms. Nichter also discussed the trend toward greater liquidity and transparency through separate account structures.

Separate accounts are something that more and more investors are seeking but there are many considerations for managers.  Specifically separate accounts can be a drain on resources, especially if the investors request their own specific administrators or auditors.  Because of the greater amount of resources which need to go into the back office to handle what is in essence a more traditional asset management business, the manager must be ready to change the business model to a certain extent.  Specific issues will include:

  • having a robust trade allocation policy
  • understanding that there is likely to be a disparity of performance
  • potential registration issues
  • potential integration issues
  • performance reporting issues (may need to go back to GIPS)

Questions and Conclusion

After the panel finished their discussion the floor was open to questions.  During this time there were a number of good questions.  One issue focused on what will performance fees look like going forward which led to a discussion about creative performance fees (like instituting some sort of clawback provision like what is found in private equity funds).  Another issue was whether and to what extent the Managed Funds Association will be representing the industry during this time of legislative/regulatory changes.  The answer is that the MFA will be doing everything it possibly can to represent the hedge fund industry and it is our job to make sure that the MFA knows how the industry feels about many of the current legislative proposals.

SEC Chairman Discusses Potential New IA Custody Rules

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Hedge Fund Advisors May be Impacted

Yesterday SEC Chairman Mary Schapiro discussed many new SEC initiatives in a speech given to the Society of American Business Editors and Writers.  One of the new initiatives involves those advisors who have “custody” of client assets.  With respect to such advisors, Shapiro said:

I anticipate that this proposal will include a consideration of “surprise” examinations by a certified public accountant, and a requirement that investment advisers undergo third-party compliance audits.

The tone of the speech was that of a new gunslinger who has come into town to clean up – in addition to the new custody provisions, she discussed regulatory reform and giving SEC examiners more room to initiate investigations.  Many of the ideas expressed in the speech may be worrisome to investment advisors and investors because the initiatives are likely to add significantly to the operating costs of hedge fund managers who are registered as investment advisors.  Additionally, registered managers may face increase inquiries into their business by nosy SEC examiners which will not go over well within the industry.

Below I have reprinted what I thought were important or interesting parts of the speech; the full text can be found here.

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Speech by SEC Chairman:
Address to the Society of American Business Editors and Writers

by

Chairman Mary L. Schapiro
U.S. Securities and Exchange Commission
SABEW Annual Conference 2009
Denver, Colorado
April 27, 2009

…

Policies/Rules:

Enforcement has been the most visible program at the SEC in recent history. But the financial crisis teaches us that there are policy and regulatory gaps that the SEC must also address.

Again, if investors are to have confidence in the ratings assigned to securities, that corporate boards are working on behalf of stockholders, that investment advisers are not running Ponzi schemes, that money market funds won’t break the buck, then the SEC needs to be pushing forward a real agenda of reform.

Let me just highlight a few of these:

…

Custody:

In response to major investment scams — such as Madoff — and a rash of Ponzi schemes, we will be considering two proposals as part of a package of initiatives designed to better assure the safekeeping of investor assets.

In short order, the Commission will consider a proposal to strengthen the controls applicable to investment advisers with custody of client funds and securities. I anticipate that this proposal will include a consideration of “surprise” examinations by a certified public accountant, and a requirement that investment advisers undergo third-party compliance audits.

Also, as part of this package, I have asked the staff to draft a Commission requirement that a senior officer from broker-dealers and investment advisers with custody certify that controls are in place to protect investor assets.

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Reforming the Landscape:

As a result, there is significant debate about regulatory reform — not about whether it should happen, but about what form it will take. You might say the train has left the station, but no one quite knows for sure where it will come to stop.

Whatever form it takes, I support the view that there is a need for system-wide consideration of risks to the financial system and to create mechanisms to reduce and avert such systemic risks.

But, at the same time, I believe that any reform must not — and cannot — compromise the quality of our capital markets or the protection of investors.

If we cannot show investors that we are looking out for their interests as much as the interests of the financial institutions — then we will have little success in restoring confidence.

Investors need to see that we are going after those who engage in wrongdoing. They need to see that we are forcing companies to be truthful and transparent in their reporting. They need to see that we are limiting risk in areas where substantial risk is not what they’re buying. And, they need to see that we’re rooting out fraud.

In short, they need an agency that’s there for them — and primarily them. They need an independent agency that exists not just to protect Wall Street, but to protect Main Street.

By offering that to investors, we can help to restore confidence.

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In addition, I have streamlined our enforcement procedures by no longer requiring full Commission approval to launch an investigation. And, I’ve eliminated the need for full Commission approval before negotiating a settlement with a corporate defendant.

Before these directives, enforcement attorneys will tell you that they worried about red lights at every turn — now they see green.

Additionally, I brought on a consulting firm to assess and revamp the way we handle the nearly 1 million tips and complaints we get each year. Because we do not have unlimited resources we cannot pursue every lead — we get about 2,000 every day. But we can do a better job ensuring that each tip lands on the right desk and that the person reviewing it has the necessary skills.

Further, we are looking at improving our training programs and hiring new skill sets — from financial analysis to experts in complex trading strategies. It’s all an effort to keep pace with the fraudsters and the ever-changing financial concoctions of the day.

For me, the progress cannot be fast enough.

When I review the pipeline of cases I see how much we are confronting.

  • We have approximately 150 active hedge fund investigations, some of which include possible Ponzi schemes, misappropriations, and performance smoothing.
  • We have about two dozen active municipal securities investigations possibly involving offering frauds; arbitrage-driven fraud; public corruption; and price transparency.
  • And, we have more than 50 current investigations involving Credit Default Swaps, Collateralized Debt Obligations and other derivatives-related investments.

… and that’s just a small slice.

Please contact us if you have a question on this issue or if you would like to start a hedge fund.  If you would like more information, please see our articles on starting a hedge fund.  Other related hedge fund law articles include:

Hedge Fund Adviser Registration Act of 2009

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Congressional Bill Proposed in House

In January we gave significant attention to the Hedge Fund Transparency Act of 2009 and we did not focus at all on a similar bill introduced in the House of Representatives.   The Hedge Fund Adviser Registration Act of 2009, introduced on January 27, would change the Investment Advisers Act of 1940 to require those managers with more than $30 million in assets to register as investment advisors with the SEC (for background, please see 203(b)(3) exemption).  The Hedge Fund Transparency Act takes a decidedly different route to regulation – it would require hedge fund managers, under the Investment Company Act of 1940 , to register as investment advisors and it would also require hedge funds to submit certain information to the SEC.

The fate of both of these bills is currently in question.  It seems as though Congress and the SEC are waiting for President Obama and Treasury Secretary Geithner to develop a plan for a comprehensive regulatory system.  While we remain in this holding pattern it seems likely that any regulatory changes are months and months away.

The full text of the Registration Act are reprinted below along with a press release announcing the proposed measure.  Other related hedge fund law articles include:

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Hedge Fund Adviser Registration Act of 2009 (Introduced in House)

HR 711 IH

111th CONGRESS

1st Session

H. R. 711

To amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisors with less than 15 clients.

IN THE HOUSE OF REPRESENTATIVES

January 27, 2009

Mr. CAPUANO (for himself and Mr. CASTLE) introduced the following bill; which was referred to the Committee on Financial Services

A BILL

To amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisors with less than 15 clients.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Hedge Fund Adviser Registration Act of 2009′.

SEC. 2. REMOVAL OF THE PRIVATE ADVISOR EXEMPTION.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by striking subsection (b)(3).

Source

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PRESS RELEASE

Capuano, Castle Bill Would Improve Oversight of Hedge Funds

Requires money managers to register with SEC

January 27, 2009

Washington, DC — Today, Reps. Mike Castle (R-DE) and Mike Capuano (D-MA), introduced bipartisan legislation that is intended to close a loophole created in the Investment Advisors Act of 1940, which exempts hedge fund managers from registering with the Securities and Exchange Commission (SEC) if they have less than 15 clients. The Hedge Fund Managers Registration Act, would require anyone who manages hedge funds to register with the SEC, and therefore improves federal oversight of these investments.

“This measure would require all hedge fund managers to register with the SEC so that their actions on behalf of investors are transparent,” said Rep. Capuano. “I have long advocated this simple step as a way to better understand how hedge fund managers are operating, and how they are investing the resources of their clients. In addition to providing us with basic census information on hedge funds, this measure can be used to detect and deter fraudulent practices and risky behavior before it’s too late.”

“Hedge funds are a $1.5 trillion industry that account for roughly 30 percent of U.S. stock trading, but also have tremendous presence in other areas of our markets. Without greater attention and oversight to protect investors from fraud, hedge funds pose systemic risk to our economy,” said Rep. Castle, senior member on the House Financial Services Committee. “As we work to help regain our economic health, I believe we can and should scrutinize money managers more carefully and begin to reclaim some order in equity markets. I am hopeful that this legislation will work as a tool to help protect investors from becoming victims. This is the first in a series of reforms I intend to strongly advocate in the coming months.”

—

Contact: Alison M. Mills (617) 621-6208
Contact: Stephanie Fitzpatrick (202) 225-4165 (Rep. Castle)

New Hedge Fund Laws Proposed in Connecticut

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State to Increase Regulation of Hedge Funds

(www.hedgefundlawblog.com)  Connecticut, home of many of the biggest hedge funds in the world, may begin regulating hedge funds in a heavy handed manner.  Recently state lawmakers have introduced three bills (Raised Bill No. 953, Raised Bill No. 6477 and Raised Bill No. 6480) which would greatly increase oversight of hedge funds which have a presence in Connecticut.   This article provides an overview of the three raised bills and provides reprints the actual text of these bills.

Raised Bill No. 953

The largest of the three bills, No. 953 has the following central features:

  • Definitions certain terms (including the term “Hedge Fund”) which are used throughout the bill.
  • Provides that, starting in 2011, hedge funds may not have individual investors  who do not have $2.5 million in “investment assets” (different than net worth)
  • Provides that, starting in 2011, hedge funds may not have institutional investors who do not have $5 million in “investment assets”
  • Provides that funds must disclose certain conflicts of interest of the manager
  • Provides that funds must disclose the existence of side letters
  • Requires an annual audit (beginning in 2010)

The above provisions would apply to those funds which have an office in Connecticut where employees regularly conduct business on behalf of the fund.   It is currently unclear whether there will be any sort of grandfathering provisions for those funds which currently have investors who do  not meet the “investment assets” threshold.   Another interesting part of the bill is that it defines a hedge fund with reference to Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act.  The recently proposed Hedge Fund Transparency Act would actually eliminate these sections and add new Section 6(a)(6) and Section 6(a)(7).

Raised Bill No. 6477

The next bill is No. 6477 which would require hedge funds to be regulated by the Connecticut Banking Commission.  The bill requires hedge funds to purchase a $500 license issued by the Connecticut Banking Commissioner prior to conducting business in Connecticut.  The license would need to be purchased each year.  The bill also provides the Banking Commission with authority to adopt regulations.

This bill is interesting because it is fundamentally different from most hedge fund regulations which seek to regulate the management company through investment advisor registration.  This bill regulates the fund entity (as opposed to the management company) and does so through the power of the state to regulate banking.   Right now it looks like this bill will apply to all hedge funds, even those who do not utilize leverage.  It is not currently clear why or how the Banking Commission has jurisdiction non-banking private pools of capital, especially for those funds which do not utilize any sort of leverage.

It is also interesting to note that No. 6477 would apply regardless of the registration status of the fund’s management company.  This means that a fund could be subject to SEC oversight and may also be subject to direct oversight by the Connecticut Department of Banking (“DOB”), which means the DOB could presumably conduct audits of the fund.  Of course, this could potentially greatly increase operational costs for hedge funds with an office in Connecticut.

Raised Bill No. 6480

The final bill is No. 6480 which would require Connecticut based hedge funds with Connecticut pension fund investors to disclose detailed portfolio information to such pension funds upon request.  It goes without saying that this bill is likely to receive a considerable amount of scrutiny from the Connecticut hedge fund community.

Conclusion

The hedge fund industry continues to be a major focus of both state and federal lawmakers who are anxious to start regulating these vehicles.  Unfortunately we are witnessing a patchwork approach to regulation where there is little communication between the states and the federal lawmakers.  If other states follow Connecticut’s lead then we face the potential situation where funds in each state will need to follow state specific laws enacted by quick-to-legislate, out-of-touch lawmakers.   Efficiency in the securities markets is undercut by overlapping and unnecessary regulations – both managers and investors would be better served by a comprehensive effort to revise the securities laws at the federal and state levels.

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Raised Bill No. 953
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING HEDGE FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) As used in this section:

(1) “Hedge fund” means any investment company, as defined in Section 3(a)(1) of the Investment Company Act of 1940, located in this state (A) that claims an exemption under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940; (B) whose offering of securities is exempt under the private offering safe harbor criteria in Rule 506 of Regulation D of the Securities Act; and (C) that meets any other criteria as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section. A hedge fund is located in this state if such fund has an office in Connecticut where employees regularly conduct business on behalf of the hedge fund;

(2) “Institutional investor” means an investor other than an individual investor including, but not limited to, a bank, savings and loan association, registered broker, dealer, investment company, licensed small business investment company, corporation or any other legal entity;

(3) “Investment assets” includes any security, real estate held for investment purposes, bank deposits, cash and cash equivalents, commodity interests held for investment purposes and such other forms of investment assets as may be established by the Banking Commissioner in regulations adopted under subsection (f) of this section;

(4) “Investor” means any holder of record of a class of equity security in a hedge fund;

(5) “Major litigation” means any legal proceeding in which the hedge fund is a party which if decided adversely against the hedge fund would require such fund to make material future expenditures or have a material adverse impact on the hedge fund’s financial position;

(6) “Manager” means an individual located in this state who has direct and personal responsibility for the operation and management of a hedge fund; and

(7) “Material” means, with respect to future expenditures or adverse impact on the hedge fund’s financial position, more than one per cent of the assets of the hedge fund.

(b) On or after January 1, 2011, no hedge fund shall consist of individual investors who, individually or jointly with a spouse, have less than two million five hundred thousand dollars in investment assets or institutional investors that have less than five million dollars in assets.

(c) The manager shall disclose to each investor or prospective investor in a hedge fund, not later than thirty days before any investment in the hedge fund, any financial or other interests the manager may have that conflict with or are likely to impair, the manager’s duties and responsibilities to the fund or its investors.

(d) The manager shall disclose, in writing, to each investor in a hedge fund (1) any material change in the investment strategy and philosophy of the fund and the departure of any individual employed by such fund who exercises significant control over the investment strategy or operation of the fund, (2) the existence of any side letters provided to investors in the fund, and (3) any major litigation involving the fund or governmental investigation of the fund.

(e) On January 1, 2010, and annually thereafter, the manager shall disclose, in writing, to each investor in a hedge fund (1) the fee schedule to be paid by the hedge fund including, but not limited to, management fees, brokerage fees and trading fees, and (2) a financial statement indicating the investor’s capital balance that has been audited by an independent auditing firm.

(f) The Banking Commissioner may adopt regulations, in accordance with chapter 54 of the general statutes, to implement the provisions of this section.\

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Raised Bill No. 6477
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT CONCERNING THE LICENSING OF HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) (a) No person shall establish or conduct business in this state as a hedge fund or private capital fund without a license issued by the Banking Commissioner. Applicants for such license shall apply to the Department of Banking on forms prescribed by the commissioner. Each application shall be accompanied by a fee of five hundred dollars. Such license shall be valid for one year and may be renewed upon payment of a fee of five hundred dollars and in accordance with the regulations adopted pursuant to subsection (b) of this section.

(b) The Banking Commissioner shall adopt regulations in accordance with the provisions of chapter 54 of the general statutes for purposes of this section.

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Raised Bill No. 6480
January Session, 2009

Referred to Committee on Banks
Introduced by: (BA)

AN ACT REQUIRING THE DISCLOSURE OF FINANCIAL INFORMATION TO PROSPECTIVE INVESTORS IN HEDGE FUNDS AND PRIVATE CAPITAL FUNDS.

Be it enacted by the Senate and House of Representatives in General Assembly convened:

Section 1. (NEW) (Effective October 1, 2009) Any hedge fund or private capital fund that is (1) domiciled in the state, and (2) receiving money from pension funds domiciled in the state shall disclose to each prospective pension investor in such funds, upon request, financial information including, but not limited to, detailed portfolio information relative to the assets and liabilities of such funds.

Hedge Fund Books and Records Requirement

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Hedge Fund Regulation May Include Rule 204-2

As we have discussed, hedge fund regulation legislation has been introduced as the Hedge Fund Transparency Act.  This legislation calls for hedge funds to maintain such books and records that the SEC would require.  It is likely that the books and records required by the SEC would be substantially similar to the records required for SEC-registered investment advisors.  Those requirements are laid out in Rule 204-2 under the Investment Advisers Act.  We have provided the full text of the rule below.

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Rule 204-2 – Books and Records to Be Maintained by Investment Advisers

a. Every investment adviser registered or required to be registered under section 203 of the Act shall make and keep true, accurate and current the following books and records relating to its investment advisory business:

1. A journal or journals, including cash receipts and disbursements, records, and any other records of original entry forming the basis of entries in any ledger.

2. General and auxiliary ledgers (or other comparable records) reflecting asset, liability, reserve, capital, income and expense accounts.

3. A memorandum of each order given by the investment adviser for the purchase or sale of any security, of any instruction received by the investment adviser concerning the purchase, sale, receipt or delivery of a particular security, and of any modification or cancellation of any such order or instruction. Such memoranda shall show the terms and conditions of the order, instruction, modification or cancellation; shall identify the person connected with the investment adviser who recommended the transaction to the client and the person who placed such order; and shall show the account for which entered, the date of entry, and the bank, broker or dealer by or through whom executed where appropriate. Orders entered pursuant to the exercise of discretionary power shall be so designated.

4. All check books, bank statements, cancelled checks and cash reconciliations of the investment adviser.

5. All bills or statements (or copies thereof), paid or unpaid, relating to the business of the investment adviser as such.

6. All trial balances, financial statements, and internal audit working papers relating to the business of such investment adviser.

7. Originals of all written communications received and copies of all written communications sent by such investment adviser relating to (i) any recommendation made or proposed to be made and any advice given or proposed to be given, (ii) any receipt, disbursement or delivery of funds or securities, or (iii) the placing or execution of any order to purchase or sell any security: Provided, however, (a) That the investment adviser shall not be required to keep any unsolicited market letters and other similar communications of general public distribution not prepared by or for the investment adviser, and (b) that if the investment adviser sends any notice, circular or other advertisement offering any report, analysis, publication or other investment advisory service to more than 10 persons, the investment adviser shall not be required to keep a record of the names and addresses of the persons to whom it was sent; except that if such notice, circular or advertisement is distributed to persons named on any list, the investment adviser shall retain with the copy of such notice, circular or advertisement a memorandum describing the list and the source thereof.

8. A list or other record of all accounts in which the investment adviser is vested with any discretionary power with respect to the funds, securities or transactions of any client.

9. All powers of attorney and other evidences of the granting of any discretionary authority by any client to the investment adviser, or copies thereof.

10. All written agreements (or copies thereof) entered into by the investment adviser with any client or otherwise relating to the business of such investment adviser as such.

11. A copy of each notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons (other than persons connected with such investment adviser), and if such notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication recommends the purchase or sale of a specific security and does not state the reasons for such recommendation, a memorandum of the investment adviser indicating the reasons therefor.

12.

i. A copy of the investment adviser’s code of ethics adopted and implemented pursuant to Rule 204A-1 that is in effect, or at any time within the past five years was in effect;

ii. A record of any violation of the code of ethics, and of any action taken as a result of the violation; and

iii. A record of all written acknowledgments as required by Rule 204A-1(a)(5) for each person who is currently, or within the past five years was, a supervised person of the investment adviser.

13.

i. A record of each report made by an access person as required by Rule 204A-1(b), including any information provided under paragraph (b)(3)(iii) of that rule in lieu of such reports;

ii. A record of the names of persons who are currently, or within the past five years were, access persons of the investment adviser; and

iii. A record of any decision, and the reasons supporting the decision, to approve the acquisition of securities by access persons under Rule 204A-1(c), for at least five years after the end of the fiscal year in which the approval is granted.

iv. An investment adviser shall not be deemed to have violated the provisions of this paragraph (a)(13) because of his failure to record securities transactions of any advisory representative if he establishes that he instituted adequate procedures and used reasonable diligence to obtain promptly reports of all transactions required to be recorded.

14. A copy of each written statement and each amendment or revision thereof, given or sent to any client or prospective client of such investment adviser in accordance with the provisions of Rule 204-3 under the Act, and a record of the dates that each written statement, and each amendment or revision thereof, was given, or offered to be given, to any client or prospective client who subsequently becomes a client.

15. All written acknowledgments of receipt obtained from clients pursuant to Rule 206(4)-3(a)(2)(iii)(B) and copies of the disclosure documents delivered to clients by solicitors pursuant to Rule 206(4)-3.

16. All accounts, books, internal working papers, and any other records or documents that are necessary to form the basis for or demonstrate the calculation of the performance or rate of return of any or all managed accounts or securities recommendations in any notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons (other than persons connected with such investment adviser); provided, however, that, with respect to the performance of managed accounts, the retention of all account statements, if they reflect all debits, credits, and other transactions in a client’s account for the period of the statement, and all worksheets necessary to demonstrate the calculation of the performance or rate of return of all managed accounts shall be deemed to satisfy the requirements of this paragraph.

17.

i. A copy of the investment adviser’s policies and procedures formulated pursuant to Rule 206(4)-7(a) of this chapter that are in effect, or at any time within the past five years were in effect, and

ii. Any records documenting the investment adviser’s annual review of those policies and procedures conducted pursuant to Rule 206(4)-7(b) of this chapter.

b. If an investment adviser subject to paragraph (a) of this section has custody or possession of securities or funds of any client, the records required to be made and kept under paragraph (a) of this section shall include:

1. A journal or other record showing all purchases, sales, receipts and deliveries of securities (including certificate numbers) for such accounts and all other debits and credits to such accounts.

2. A separate ledger account for each such client showing all purchases, sales, receipts and deliveries of securities, the date and price of each purchase and sale, and all debits and credits.

3. Copies of confirmations of all transactions effected by or for the account of any such client.

4. A record for each security in which any such client has a position, which record shall show the name of each such client having any interest in such security, the amount or interest of each such client, and the location of each such security.

c.

1. Every investment adviser subject to paragraph (a) of this section who renders any investment supervisory or management service to any client shall, with respect to the portfolio being supervised or managed and to the extent that the information is reasonably available to or obtainable by the investment adviser, make and keep true, accurate and current:

i. Records showing separately for each such client the securities purchased and sold, and the date, amount and price of each such purchase and sale.

ii. For each security in which any such client has a current position, information from which the investment adviser can promptly furnish the name of each such client, and the current amount or interest of such client.

2. Every investment adviser subject to paragraph (a) of this section that exercises voting authority with respect to client securities shall, with respect to those clients, make and retain the following:

i. Copies of all policies and procedures required by Rule 206(4)-6.

ii. A copy of each proxy statement that the investment adviser receives regarding client securities. An investment adviser may satisfy this requirement by relying on a third party to make and retain, on the investment adviser’s behalf, a copy of a proxy statement (provided that the adviser has obtained an undertaking from the third party to provide a copy of the proxy statement promptly upon request) or may rely on obtaining a copy of a proxy statement from the Commission’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system.

3. A record of each vote cast by the investment adviser on behalf of a client. An investment adviser may satisfy this requirement by relying on a third party to make and retain, on the investment adviser’s behalf, a record of the vote cast (provided that the adviser has obtained an undertaking from the third party to provide a copy of the record promptly upon request).

4. A copy of any document created by the adviser that was material to making a decision how to vote proxies on behalf of a client or that memorializes the basis for that decision.

5. A copy of each written client request for information on how the adviser voted proxies on behalf of the client, and a copy of any written response by the investment adviser to any (written or oral) client request for information on how the adviser voted proxies on behalf of the requesting client.

d. Any books or records required by this section may be maintained by the investment adviser in such manner that the identity of any client to whom such investment adviser renders investment supervisory services is indicated by numerical or alphabetical code or some similar designation.

e.

1. All books and records required to be made under the provisions of paragraphs (a) to (c)(1)(i), inclusive, and (c)(2) of this rule (except for books and records required to be made under the provisions of paragraphs (a)(11), (a)(12)(i), (a)(12)(iii), (a)(13)(ii), (a)(13)(iii), (a)(16), and (a)(17)(i) of this section), shall be maintained and preserved in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on such record, the first two years in an appropriate office of the investment adviser.

2. Partnership articles and any amendments thereto, articles of incorporation, charters, minute books, and stock certificate books of the investment adviser and of any predecessor, shall be maintained in the principal office of the investment adviser and preserved until at least three years after termination of the enterprise.

3.

i. Books and records required to be made under the provisions of paragraphs (a)(11) and (a)(16) of this rule shall be maintained and preserved in an easily accessible place for a period of not less than five years, the first two years in an appropriate office of the investment adviser, from the end of the fiscal year during which the investment adviser last published or otherwise disseminated, directly or indirectly, the notice, circular, advertisement, newspaper article, investment letter, bulletin or other communication.

ii. Transition rule. If you are an investment adviser to a private fund as that term is defined in Rule 203(b)(3)-1, and you were exempt from registration under section 203(b)(3) of the Act prior to February 10, 2005, paragraph (e)(3)(i) of this section does not require you to maintain or preserve books and records that would otherwise be required to be maintained or preserved under the provisions of paragraph (a)(16) of this section to the extent those books and records pertain to the performance or rate of return of such private fund or other account you advise for any period ended prior to February 10, 2005, provided that you were not registered with the Commission as an investment adviser during such period, and provided further that you continue to preserve any books and records in your possession that pertain to the performance or rate of return of such private fund or other account for such period.

f. An investment adviser subject to paragraph (a) of this section, before ceasing to conduct or discontinuing business as an investment adviser shall arrange for and be responsible for the preservation of the books and records required to be maintained and preserved under this section for the remainder of the period specified in this section, and shall notify the Commission in writing, at its principal office, Washington, D.C. 20549, of the exact address where such books and records will be maintained during such period.

g. Micrographic and electronic storage permitted.

1. General. The records required to be maintained and preserved pursuant to this part may be maintained and preserved for the required time by an investment adviser on:

i. Micrographic media, including microfilm, microfiche, or any similar medium; or

ii. Electronic storage media, including any digital storage medium or system that meets the terms of this section.

2. General requirements. The investment adviser must:

i. Arrange and index the records in a way that permits easy location, access, and retrieval of any particular record;

ii. Provide promptly any of the following that the Commission (by its examiners or other representatives) may request:

A. A legible, true, and complete copy of the record in the medium and format in which it is stored;

B. A legible, true, and complete printout of the record; and

C. Means to access, view, and print the records; and

iii. Separately store, for the time required for preservation of the original record, a duplicate copy of the record on any medium allowed by this section.

3. Special requirements for electronic storage media. In the case of records on electronic storage media, the investment adviser must establish and maintain procedures:

i. To maintain and preserve the records, so as to reasonably safeguard them from loss, alteration, or destruction;

ii. To limit access to the records to properly authorized personnel and the Commission (including its examiners and other representatives); and

iii. To reasonably ensure that any reproduction of a non-electronic original record on electronic storage media is complete, true, and legible when retrieved.

h.

1. Any book or other record made, kept, maintained and preserved in compliance with Rule 17a-3 and Rule 17a-4 under the Securities Exchange Act of 1934, which is substantially the same as the book or other record required to be made, kept, maintained and preserved under this section, shall be deemed to be made, kept maintained and preserved in compliance with this section.

2. A record made and kept pursuant to any provision of paragraph (a) of this section, which contains all the information required under any other provision of paragraph (a) of this section, need not be maintained in duplicate in order to meet the requirements of the other provision of paragraph (a) of this section.

i. As used in this section the term “discretionary power” shall not include discretion as to the price at which or the time when a transaction is or is to be effected, if, before the order is given by the investment adviser, the client has directed or approved the purchase or sale of a definite amount of the particular security.

j.

1. Except as provided in paragraph (j)(3) of this section, each non-resident investment adviser registered or applying for registration pursuant to section 203 of the Act shall keep, maintain and preserve, at a place within the United States designated in a notice from him as provided in paragraph (j)(2) of this section true, correct, complete and current copies of books and records which he is required to make, keep current, maintain or preserve pursuant to any provisions of any rule or regulation of the Commission adopted under the Act.

2. Except as provided in paragraph (j)(3) of this section, each nonresident investment adviser subject to this paragraph (j) shall furnish to the Commission a written notice specifying the address of the place within the United States where the copies of the books and records required to be kept and preserved by him pursuant to paragraph (j)(1) of this section are located. Each non-resident investment adviser registered or applying for registration when this paragraph becomes effective shall file such notice within 30 days after such rule becomes effective. Each non-resident investment adviser who files an application for registration after this paragraph becomes effective shall file such notice with such application for registration.

3. Notwithstanding the provisions of paragraphs (j)(1) and (2) of this section, a non-resident investment adviser need not keep or preserve within the United States copies of the books and records referred to in said paragraphs (j)(1) and (2), if:

i. Such non-resident investment adviser files with the Commission, at the time or within the period provided by paragraph (j)(2) of this section, a written undertaking, in form acceptable to the Commission and signed by a duly authorized person, to furnish to the Commission, upon demand, at its principal office in Washington, D.C., or at any Regional Office of the Commission designated in such demand, true, correct, complete and current copies of any or all of the books and records which he is required to make, keep current, maintain or preserve pursuant to any provision of any rule or regulation of the Commission adopted under the Act, or any part of such books and records which may be specified in such demand. Such undertaking shall be in substantially the following form:

The undersigned hereby undertakes to furnish at its own expense to the Securities and Exchange Commission at its principal office in Washington, D.C. or at any Regional Office of said Commission specified in a demand for copies of books and records made by or on behalf of said Commission, true, correct, complete and current copies of any or all, or any part, of the books and records which the undersigned is required to make, keep current or preserve pursuant to any provision of any rule or regulation of the Securities and Exchange Commission under the Investment Advisers Act of 1940. This undertaking shall be suspended during any period when the undersigned is making, keeping current, and preserving copies of all of said books and records at a place within the United States in compliance with Rule 204-2(j) under the Investment Advisers Act of 1940. This undertaking shall be binding upon the undersigned and the heirs, successors and assigns of the undersigned, and the written irrevocable consents and powers of attorney of the undersigned, its general partners and managing agents filed with the Securities and Exchange Commission shall extend to and cover any action to enforce same.

and

ii. Such non-resident investment adviser furnishes to the Commission, at his own expense 14 days after written demand therefor forwarded to him by registered mail at his last address of record filed with the Commission and signed by the Secretary of the Commission or such person as the Commission may authorize to act in its behalf, true, correct, complete and current copies of any or all books and records which such investment adviser is required to make, keep current or preserve pursuant to any provision of any rule or regulation of the Commission adopted under the Act, or any part of such books and records which may be specified in said written demand. Such copies shall be furnished to the Commission at its principal office in Washington, D.C., or at any Regional Office of the Commission which may be specified in said written demand.

4. For purposes of this rule the term non-resident investment adviser shall have the meaning set out in Rule 0-2(d)(3) under the Act. [Editor’s note: There is no paragraph (d) to Rule 0-2. The term non-resident is defined in Rule 0-2(b)(2).]

k. Every investment adviser that registers under section 203 of the Act after July 8, 1997 shall be required to preserve in accordance with this section the books and records the investment adviser had been required to maintain by the State in which the investment adviser had its principal office and place of business prior to registering with the Commission.

Hedge Fund Registration Quick Facts

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Hedge Fund Transparency Act of 2009 Overview

This article provides an overview of the major provisions of the Hedge Fund Transparency Act of 2009.  There are two major things that the HFTA does: (1) increases regulation of hedge funds under the Investment Company Act and (2) requires hedge funds to adopt anti-money laundering programs.

Changes under the Investment Company Act

The HFTA replaces Section 3(c)(1) of the Investment Company Act  with a new Section 6(a)(6).  Section 3(c)(7) is replaced by new Section 6(a)(6).  These new sections, which are functionally equivalent to Section 3(c)(1) and Section 3(c)(7) respectively, will exempt hedge funds from the mutual fund regulations that are found in the Investment Company Act, provided that the hedge funds comply with the provisions of Section 6(g).

Section 6(g) applies to hedge funds with assets under management (AUM) of $50 million or more.  Those hedge funds which have less than $50 million of AUM will not be subject to Section 6(g).  Section 6(g) requires:

1.  The hedge fund manager to register with the SEC.  (HFLB note: I believe the statute is not clearly written.  It seems that the hedge fund itself would be required to register with the SEC which does not make sense.)

2.  Maintain certain books and records as required by the SEC.  This requirements is likely to look like the current books and records rule of the Investment Advisors Act (Rule 204-2), for more background please see article on Investment Advisor Compliance Information.

3.  Cooperate with the SEC with regard to any request for information or examination.

4.  File the following information with the SEC on a no less than annual basis:

a.  The name and current address of each investor in the fund.

b.  The name and current address of the primary accountant and broker of the fund.

c.  An overview of the fund’s ownership structure.

d.  An overview of the fund’s affiliations, if any, with financial institutions.

e.  A statement of the fund’s terms (i.e. minimum investment).

f.  Other information including the total number of investors and the current value of the fund’s assets.

The SEC is charged with issuing forms and guidance on the implementation of the above.  Such forms and guidance must be issued within 180 days from the enactment of the HFTA.

New AML Requirements

The HFTA requires the Secretary of the Treasury (in consultations with the Chairman of the SEC and the Chairman of the CFTC) to establish AML requirements for hedge funds.  The bill sets aggressive timelines for drafting and implementation of the rules.

Hedge Fund Transparency Act Analysis

In the current politically charged environment it is not surprising that a hedge fund regulation law is being contemplated.  What is interesting, however, is the way that Grassley and Levin have chosen to regulate hedge funds.  The prior hedge fund registration rule, promulgated by the SEC, was enacted under the Investment Advisors Act – in essence requiring hedge fund managers (and not the hedge fund itself) to register as Investment Advisors with the SEC.  The Hedge Fund Transparency Act does not follow this path – instead, it regulates hedge funds under the Investment Company Act by modifying the current exemptions which hedge funds enjoy under the act.  In essence the changes subject hedge funds to a kind of light version of the mutual fund regulations.  In this way Congress is going past previous registration by regulating the hedge fund vehicle, as well as the hedge fund management company through the registration requirement.

While it is no surprise that regulation and registration has reached the hedge fund industry, one aspect of the bill is surprising.  The act would require hedge funds to disclose the names and addresses of each investor in the fund.  These names and addresses would be made available to the general public through an electronic searchable format to be developed by the SEC.  Hedge fund investors are notoriously protective of their privacy and I cannot imagine that there will not be pushback by the hedge fund industry on this point.

Another consequence of investment advisor registration is that hedge fund managers (if not currently regulated by the state in which their business resides) may be subject to certain state investment advisory rules including a “notice” filing requirement.  Depending on the nature of the management company’s business, some employees may need to register as investment advisor representatives at the state level which generally requires an employee to have passed the Series 65 exam.  We will keep you updated on this possibility as we learn more about the HFTA over time.

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Please contact us if you have any questions releted to this post or registering your management company as an investment advisor with the SEC.  Other related posts include:

Hedge Fund Transparency Act Text

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Below is the actual text of the Hedge Fund Transparency Act.  (For the bill with page and line numbers please see: Hedge Fund Transparency Act (pdf)).

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111TH CONGRESS
1ST SESSION
S.

To require hedge funds to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

Mr. GRASSLEY (for himself and Mr. LEVIN) introduced the following bill; which was read twice and referred to the Committee on

A BILL

To require hedge funds to register with the Securities and Exchange Commission, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the “Hedge Fund Transparency Act”.

SEC. 2. HEDGE FUND REGISTRATION REQUIREMENTS.

(a) DEFINITION OF INVESTMENT COMPANY.—Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)) is amended—(1) by striking paragraph (1); (2) by striking paragraph (7); (3) by redesignating paragraphs (2) through (6) as paragraphs (1) through (5), respectively; and (4) by redesignating paragraphs (8) through (14) as paragraphs (6) through (12), respectively.

(b) ADDITIONAL EXEMPTIONS.—Section 6 of the Investment Company Act of 1940 (15 U.S.C. 80a-6) is amended—(1) in subsection (a), by adding at the end the following:

“(6)(A) Subject to subsection (g), any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons, and which is not making and does not presently propose to make a public offering of its securities.

“(B) For purposes of this paragraph and paragraph (7), beneficial ownership—

“(i) by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 percent or more of the outstanding voting securities of the issuer, and is or, but for the exemption provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of the outstanding securities (other than short-term paper) of such company; and

“(ii) by any person who acquires securities or interests in securities of an issuer described in this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or any other involuntary event.

“(7)(A) Subject to subsection (g), any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of the acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or any other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

“(B) Notwithstanding subparagraph (A), an issuer is exempt under this paragraph if—”(i) in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if—”(I) such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and “(II) at the time at which such persons initially acquired the securities of such issuer, the issuer was exempt under paragraph (6); and “(ii) prior to availing itself of the exemption provided by this paragraph—

“(I) such issuer has disclosed to each beneficial owner that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and

“(II) concurrently with or after such disclosure, such issuer has provided each beneficial owner with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for the proportionate share of that person of the net assets of the issuer.

“(C) Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to the proportionate share of that person of the net assets of the issuer, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of the share of that person in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).

“(D) An issuer that is exempt under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) (15 U.S.C. 80a-12(d)(1)(A)(i) and (B)(i)) relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.

“(E) For purposes of determining compliance with this paragraph and paragraph (6), an issuer that is otherwise exempt under this paragraph and an issuer that is otherwise exempt under paragraph (6) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer exempt under paragraph (6) are beneficially owned by not more than 100 persons, or whether the outstanding securities of the issuer exempt under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (6).”; and

(2) by adding at the end the following:

“(g) LIMITATION ON EXEMPTIONS FOR LARGE INVESTMENT COMPANIES.—

“(1) IN GENERAL.—An investment company with assets, or assets under management, of not less than $50,000,000 is exempt under subsection (a)(6) or (a)(7) only if that company—

“(A) registers with the Commission;
“(B) files an information form with the Commission under paragraph (2);
“(C) maintains such books and records as the Commission may require; and
“(D) cooperates with any request for information or examination by the Commission.

“(2) INFORMATION FORM.—The information form required under paragraph (1) shall be filed at such time and in such manner as the Commission shall require, and shall—

‘(A) be filed electronically;
“(B) be filed not less frequently than once every 12 months;
“(C) include—
“(i) the name and current address of—
“(I) each natural person who is a beneficial owner of the investment company;
“(II) any company with an ownership interest in the investment company; and
“(III) the primary accountant and primary broker used by the investment company;
“(ii) an explanation of the structure of ownership interests in the investment company;
“(iii) information on any affliation that the investment company has with another financial institution;
“(iv) a statement of any minimum investment commitment required of a limited partner, member, or other investor;
“(v) the total number of any limited partners, members, or other investors; and
“(vi) the current value of—
“(I) the assets of the investment company; and
“(II) any assets under management by the investment company; and

“(D) be made available by the Commission to the public at no cost and in an electronic, searchable format.”.

SEC. 3. IMPLEMENTING GUIDANCE AND RULES.

(a) FORMS AND GUIDANCE.—Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall issue such forms and guidance as are necessary to carry out this Act.

(b) RULES.—The Securities and Exchange Commission may make a rule to carry out this Act.

8 SEC. 4. ANTI–MONEY LAUNDERING OBLIGATIONS.

(a) PURPOSE.—It is the purpose of this section to safeguard against the financing of terrorist organizations and money laundering.

(b) IN GENERAL.—An investment company that relies on paragraph (6) or (7) of section 6(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-6(a)(6) and (7)), as amended by this Act, as the basis for an exemption under that Act shall establish an anti-money laundering program and shall report suspicious transactions under subsections (g) and (h) of section 5318 of title 31, United States Code.

(c) RULEMAKING.—

(1) IN GENERAL.—The Secretary of the Treasury, in consultation with the Chairman of the Securities and Exchange Commission and the Chairman of the Commodity Futures Trading Commission, shall, by rule, establish the policies, procedures, and controls necessary to carry out subsection (b).

(2) CONTENTS.—The rule required by paragraph (1)—

(A) shall require that each investment company that receives an exemption under paragraph (6) or (7) of section 6(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-6(a)(6) and (7)), as amended by this Act, shall—

(i) use risk–based due diligence policies, procedures, and controls that are reasonably designed to ascertain the indentity of and evaluate any foreign person (including, where appropriate, the nominal and beneficial owner or beneficiary of a foreign corporation, partnership, trust, or other foreign entity) that supplies or plans to supply funds to be invested with the advice or assistance of such investment company; and

(ii) be subject to section 5318(k)(2) of title 31, United States Code; and (B) may incorporate elements of the proposed rule for unregistered investment companies published in the Federal Register on September 26, 2002 (67 Fed. Reg. 60617) (relating to anti–money laundering programs).

(3) PUBLICATION DATE.—The Secretary of the Treasury, shall—

(A) propose the rule required by this subsection not later than 90 days after the date of enactment of this Act; and

(B) issue the rule required by this subsection in final form not later than 180 days after the date of enactment of this Act.

(d) EFFECTIVE DATE.—Subsection (b) shall take effect 1 year after the date of enactment of this Act, whether or not a final rule is issued under subsection (c), and the failure to issue such rule shall in no way affect the enforceability of this section.

SEC. 5. TECHNICAL CORRECTIONS.

(a) SECURITIES ACT OF 1933.—Section 3(a) of the Securities Act of 1933 (15 U.S.C. 77c(a)) is amended—(1) in paragraph (2)—(A) by striking “section 3(c)(3)” and inserting “section 3(c)(2)”; and (B) by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; (2) in paragraph (4), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (3) in paragraph (13), by striking “section (3)(c)(14)” and inserting “section 3(c)(12)”.

(b) SECURITIES EXCHANGE ACT OF 1934.—The Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) is amended—

(1) in section 3(a) (15 U.S.C. 78c(a))—(A) in paragraph (12)(A)—(i) in clause (iii), by striking “section 3(c)(3)” and inserting “section 3(c)(2)”; (ii) in clause (v), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (iii) in clause (vi), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; (B) in paragraph (12)(C), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; and (C) in paragraph (54)(A)—(i) in clause (ii), by striking “exclusion from the definition of investment company pursuant to section 3(c)(7)” and inserting “exemption under section 6(a)(7)”; and (ii) in clause (vii), by striking “section 3(c)(2)” and inserting “section 3(c)(1)”; (2) in section 3(g) (15 U.S.C. 78c(g)) by striking “section 3(c)(14)” each place that term appears and inserting “section 3(c)(12)”; and (3) in section 12(g)(2) (15 U.S.C. 78l(g)(2))—(A) in subparagraph (D), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (B) in subparagraph (H), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”.

(c) INVESTMENT COMPANY ACT OF 1940.—The Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) is amended—

(1) in section 2(a)(51) (15 U.S.C. 80a-2(a)(51))—(A) in subparagraph (A)(i), by striking “excepted under section 3(c)(7)” and inserting “exempt under section 6(a)(7)”; and (B) in subparagraph (C)—(i) by striking “that, but for the exceptions provided for in paragraph (1) or (7) of section 3(c), would be an investment company (hereafter in this paragraph referred to as an ‘excepted investment company’)” and inserting “that is exempt under paragraph (6) or (7) of section 6(a) (hereafter in this paragraph referred to as an ‘exempt investment company’)”; (ii) by striking “section 3(c)(1)(A)” and inserting “section 6(a)(6)(B)(i)”; and (iii) by striking “excepted” each place that term appears and inserting “any exempt”;

(2) in section 6 (15 U.S.C. 80a-6)—(A) in subsection (a)—(i) in paragraph (2), by striking “section 3(c)(1)” and inserting “section 6(a)(6)”; and (ii) in paragraph (5)(A)(iv), by striking “that would be an investment company except for the exclusions from the definition of the term ‘investment company’ under paragraph (1) or (7) of section 3(c)” and inserting “that is exempt under paragraph (6) or (7) of section 6(a)”; and (B) in subsection (f), by striking “excluded from the definition of an investment company by section 3(c)(1)” and inserting “exempt under section 6(a)(6)”;

(3) in section 7(e) (15 U.S.C. 80a-7(e)), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and

(4) in section 30 (15 U.S.C. 80a-29) in each of subsections (i) and (j), by striking “section 3(c)(14)” each place that term appears and inserting “section 3(c)(12)”.

(d) INVESTMENT ADVISERS ACT OF 1940.—The Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) is amended—

(1) in section 203(b) (15 U.S.C. 80b-3(b))—(A) in paragraph (4) by striking “section 3(c)(10)” each place that term appears and inserting “section 3(c)(8)”; and (B) in paragraph (5), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; and (2) in section 205(b) (15 U.S.C. 80b-5(b))— (A) in paragraph (2)(B), by striking “section 3(c)(11)” and inserting “section 3(c)(9)”; and (B) in paragraph (4), by striking “excepted from the definition of an investment company under section 3(c)(7)” and inserting “exempt under section 6(a)(7)”.

(e) INTERNAL REVENUE CODE OF 1986.—Section 851(a)(2) of the Internal Revenue Code of 1986 (relating to the definition of regulated investment company) is amended by striking “section 3(c)(3)” and inserting “section 3(c)(2)”.

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Hedge Fund Registration Bill Announced

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Senators Grassley and Levin Introduced Bill Requiring Hedge Fund Registration

A new bill called the Hedge Fund Transparency Act was introduced today by Senators Chuck Grassley and Carl Levin.  A press release from Grassley’s website explains the bill.

More to be forthcoming…

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For Immediate Release
January 29, 2009

Grassley and Levin introduce hedge fund transparency bill

WASHINGTON – Senators Chuck Grassley and Carl Levin introduced legislation today to close a loophole in securities law that allows hedge funds to operate under a cloak of secrecy.

The Hedge Fund Transparency Act of 2009 would clarify current law to remove any doubt that the Securities and Exchange Commission has the authority to require hedge funds to register, so the government knows who they are and what they’re doing. It would close the loophole previously used by hedge funds to escape the definition of an “investment company” under the Investment Company Act of 1940. Hedge funds that want to avoid the requirements of the Investment Company Act would be exempt only if they file basic disclosure forms and cooperate with requests for information from the Securities and Exchange Commission.

“There wasn’t much of an appetite for this sort of legislation before the financial crisis. I hope attitudes have changed and that Congress takes up this important legislation without delay,” Grassley said. “A major cause of the current crisis is a lack of transparency. The wizards on Wall Street figured out a million clever ways to avoid the transparency sought by the securities regulations adopted during the 1930s. Instead of the free flow of reliable information that markets need to function properly, today we have confusion and uncertainty fueling an economic crisis.” The bill introduced today is a version of legislation filed in two years ago by Grassley (S.1402) but never considered by Congress.

“Hedge funds control massive sums of money, and although they can cause serious damage to investors, other financial firms, and to the entire U.S. financial market, they are largely unregulated,” said Levin. “If the events of the last year have taught us anything, it’s that we need to regulate firms that are big enough to destabilize our economy if they fail. It’s time to subject financial heavyweights like hedge funds to federal regulation and oversight to protect our investors, markets, and financial system.”

Grassley said that Levin made an important addition to the transparency legislation in making clear that hedge funds have the same obligations under our money laundering statutes as other financial institutions. The bill introduced today would require hedge funds to establish anti-money laundering programs and report suspicious transactions.

The senators said their legislation is needed because of a 2006 decision by the D.C. Circuit Court of Appeals which overturned a regulation imposed by the Securities and Exchange Commission requiring hedge funds to register. The court said the Securities and Exchange Commission was going beyond its statutory authority and effectively ended all mandatory registration of hedge funds with the Securities and Exchange Commission unless and until Congress takes action.

A summary of the legislation introduced today and floor statements by Grassley and Levin are below. The text of the bill is posted here. The bill will be referred to the Senate Committee on Banking, Housing and Urban Affairs.

Hedge Fund Transparency Act of 2009

Background: This bill is a revised version of S. 1402, which Sen. Grassley introduced in the 110th Congress. While the previous bill amended the Investment Advisers Act of 1940, this bill amends the Investment Company Act of 1940 (“ICA”). However, the purpose is the same: to make it clear that the Securities and Exchange Commission has the authority to require hedge fund registration. This version also adds a provision authored by Sen. Levin to require hedge funds to establish anti-money laundering programs and report suspicious transactions.

Hedge Fund Registration Requirements

Definition of an Investment Company: Hedge Funds typically avoid regulatory requirements by claiming the exceptions to the definition of an investment company contained in §3(c)(1) or §3(c)(7) of the ICA. This bill would remove those exceptions to the definition, transforming them to exemptions by moving the provisions, without substantive change, to new sections §6(a)(6) and §6(a)(7) of the ICA.

Requirements for Exemptions: An investment company that satisfies either §6(a)(6) or §6(a)(7) will be exempted from the normal registration and filing requirements of the ICA.  Instead, a company that meets the criteria in §6(a)(6) or §6(a)(7) but has assets under management of $50,000,000 or more, must meet several requirements in order to maintain its exemption. These requirements include:

1.     Registering with the SEC.

2.     Maintaining books and records that the SEC may require.

3.     Cooperating with any request by the SEC for information or examination.

4.     Filing an information form with the SEC electronically, at least once a year. This form must be made freely available to the public in an electronic, searchable format. The form must include:

a.      The name and current address of each individual who is a beneficial owner of the investment company.

b.     The name and current address of any company with an ownership interest in the investment company.

c.      An explanation of the structure of ownership interests in the investment company.

d.     Information on any affiliation with another financial institution.

e.      The name and current address of the investment company’s primary accountant and primary broker.

f.      A statement of any minimum investment commitment required of a limited partner, member, or investor.

g.     The total number of any limited partners, members, or other investors.

h.     The current value of the assets of the company and the assets under management by the company.

Timeframe and Rulemaking Authority: The SEC must issue forms and guidance to carry out this Act within 180 days after its enactment. The SEC also has the authority to make a rule to carry out this Act.

Anti-Money Laundering Obligations: An investment company exempt under §6(a)(6) or §6(a)(7) must establish an anti-money laundering program and report suspicious transactions under 31 U.S.C.A 5318(g) and (h). The Treasury Secretary must establish a rule within 180 days of the enactment of the Act setting forth minimum requirements for the anti-money laundering programs. The rule must require exempted investment companies to “use risk-based due diligence policies, procedures, and controls that are reasonably designed to ascertain the identity of and evaluate any foreign person that supplies funds or plans to supply funds to be invested with the advice or assistance of such investment company.” The rule must also require exempted investment companies to comply with the same requirements as other financial institutions for producing records requested by a federal regulator under 31 U.S.C. 5318(k)(2).

Floor Statement of Senator Chuck Grassley of Iowa

Thursday, January 29, 2009

Mr. President, three years ago, I started conducting oversight of the SEC. That oversight began in response to a whistleblower that came to my office complaining that SEC supervisors were impeding an investigation into a major hedge fund. Soon afterward, I came to this floor to introduce an important piece of legislation based on what I learned from my oversight. The bill was aimed at closing a loophole in our securities laws that allows hedge funds to operate under a cloak of secrecy. Unfortunately, that bill, S. 1402, was never taken-up by the Banking Committee in the last Congress.

In light of the current instability in our financial system, I think it is critical for the Senate to deal with this issue in the near future. Therefore, I am pleased that Senator Levin and I worked together to produce an even better version of the bill for the 111th Congress, which we are introducing today.

This new bill, the Hedge Fund Transparency Act, does everything the previous version did and a bit more. Like the previous version, it clarifies current law to remove any doubt that the Securities and Exchange Commission (SEC) has the authority to require hedge funds to register, so the government knows who they are and what they’re doing. It removes the loophole previously used by hedge funds to escape the definition of an “investment company” under the Investment Company Act of 1940.

Under this legislation, hedge funds that want to avoid the stringent requirements of the Investment Company Act will only be exempt if: one, they file basic disclosure forms and two, cooperate with requests for information from the Securities and Exchange Commission.

I want to thank Senator Levin for not only co-sponsoring this legislation, but also contributing a key addition to this new version of the bill. In addition to requiring basic disclosure, this version also makes it clear that hedge funds have the same obligations under our money laundering statutes as other financial institutions. They must report suspicious transactions and establish anti-money laundering programs.

One major cause of the current crisis is a lack of transparency. Markets need a free flow of reliable information to function properly. Transparency was the focus of our system of securities regulations adopted in the 1930’s. Unfortunately, over time, the wizards on Wall Street figured out a million clever ways to avoid transparency. The result is the confusion and uncertainty fueling the crisis we see today.

This bill is an important step toward renewing the commitment to transparency on Wall Street. Unfortunately, there was not much of an appetite for this sort of common sense legislation when I first introduced it before the financial crisis erupted. Hopefully, attitudes have changed given all that has happened since the collapse of Bear Stearns last March.

Hedge funds are pooled investment companies that manage billions of dollars for groups of wealthy investors in total secrecy. Hedge funds affect regular investors. They affect the markets as a whole. My oversight of the SEC convinces me that the Commission needs much more information about the activities of hedge funds in order to protect the markets. Any group of organizations that can wield hundreds of billions of dollars in market power every day should be transparent and disclose basic information about their operations to the agency that Americans rely on as their watchdog for our nations’ financial markets.

As I explained when I first introduced this bill, the SEC already attempted to oversee the hedge fund industry by regulation. Congress needs to act now because of a decision by a federal appeals court. In 2006, the D.C. Circuit Court of Appeals overturned an SEC administrative rule requiring the registration of hedge funds. That decision effectively ended all registration of hedge funds with the SEC, unless and until Congress takes action.

The Hedge Fund Transparency Act would respond to that court decision by: 1. including hedge funds in the definition of an investment company and 2. Bringing much needed transparency to this super secretive industry.

The Hedge Fund Transparency Act is a first step in ensuring that the SEC has clear authority to do what it already tried to do. Congress must act to ensure that our laws are kept up to date as new types of investments appear.

Unfortunately, this legislation hasn’t had many friends. These funds don’t want people to know what they do or who participates in them. They have fought hard to keep it that way. Well, I think that’s all the more reason to shed some sunlight on them to see what they’re up to.

I urge my colleagues to co-sponsor and support this legislation, as we work to protect all investors, large and small.

Mr. President, I yield the floor.

Floor Statement of Senator Carl Levin of Michigan (as prepared)

Thursday, January 29, 2009

Mr. President, history has proven time and again that markets are not self-policing. Today’s financial crisis is due in part to the government’s failure to regulate key market participants, including hedge funds that have become unregulated financial heavyweights in the U.S. economy. That’s why I am joining today with my colleague Senator Grassley to introduce The Hedge Fund Transparency Act.

Hedge funds sound complicated, but they are simply private investment funds in which the investors have agreed to pool their money under the control of an investment manager. What distinguishes them from other investment funds is that hedge funds are typically open only to “qualified purchasers,” an SEC term referring to institutional investors like pension funds and wealthy individuals with assets over a specified minimum amount. In addition, most hedge funds have one hundred or fewer beneficial owners. By limiting the number of their beneficial owners and accepting funds only from investors of means, hedge funds have been able to qualify for the statutory exclusions provided in Sections 80a-3(c)(1) and (7) of the Investment Company Act, and avoid the obligation to comply with that law’s statutory and regulatory requirements. In short, hedge funds have been able to operate outside the reach of the SEC.

The primary argument for allowing these funds to operate outside SEC regulation and oversight is that, because their investors are generally more experienced than the general public, they need fewer government protections and their investment funds should be permitted to take greater risks than investment funds open to the investing public which needs greater SEC protection. Indeed, the ability of hedge funds to take on more risk is the reason that many individuals and institutions choose to invest in them. These investors accept more risk because that might lead to bigger rewards.

The compensation system employed by most hedge funds encourages that risk taking. Typically, investors agree to pay hedge fund investment managers a management fee of 2 percent of the fund’s total assets, plus 20 percent of the fund’s profits. The hedge fund managers profit enormously if the fund does well, but due to the guaranteed management fee, get a hefty payment even when the fund underperforms or fails. The analysis up to now has been that if wealthy people want to take big risks with their money, all else being equal, they should be allowed to do so without the safeguards normally required for the general public. So what’s the problem with allowing their investment funds to operate outside federal regulation and oversight?

The problem is that hedge funds have gotten so big and are so entrenched in U.S. financial markets, that their actions can now significantly impact market prices, damage other market participants, and can even endanger the U.S. financial system and economy as a whole.

The systemic risks posed by hedge funds first became obvious ten years ago, in 1998. Back then, Long-Term Capital Management (LTCM) was a hedge fund that, at its peak, had more than $125 billion in assets under management and, due to massive borrowing, a total market position of roughly $1.3 trillion. When it began to falter, the Federal Reserve worried that it might unload its assets in a rush, drive down prices, and end up damaging not only other firms, but U.S. markets as a whole. To prevent a financial meltdown, the Federal Reserve worked with the private sector to engineer a rescue package.

That was just over a decade ago. Since then, according to a recent report issued by the Congressional Research Service, the hedge fund industry has expanded roughly tenfold. In 2006, the SEC testified that hedge funds represented 5 percent of all U.S. assets under management, and 30 percent of all equity trading volume in the United States. By 2007, an estimated 8,000 hedge funds were managing assets totaling roughly $1.5 trillion. The most current estimate is that 10,000 hedge funds are managing approximately $1.8 trillion in assets, after suffering losses over the last year of over $1 trillion.

In addition, over the last ten years, billions of dollars being managed by hedge funds have been provided by pension plans. A 2007 report by the U.S. Government Accountability Office (GAO) found that the amount of money that defined-benefit pension plans have invested in hedge funds has risen from about $3.2 billion in 2000, to more than $50 billion in 2006. That total is probably much higher now. And while most individual pension plans invest only a small slice of their money in hedge funds, a few go farther. For example, according to the GAO report, as of September 2006, the Missouri State Employees Retirement System had invested over 30 percent of its assets in hedge funds. Universities and charities have also directed significant assets to hedge funds. The result is that hedge fund losses threaten every economic sector in America, from the wealthy to the working class relying on pensions to our institutions of higher learning to our non-profit charities.

A third key development is that, over the last ten years, some of the largest U.S. banks and securities firms have set up their own hedge funds and used them to invest not only client funds, but also their own cash. In some cases, these hedge funds have commingled client and institutional funds and linked the fate of both to high-risk investment strategies. These hedge fund affiliates are typically owned by the same holding companies that own federally insured banks or federally regulated broker-dealers.

Because of their ownership, size and reach, their clientele, and the high-risk nature of their investments, the failure of a hedge fund today can imperil not only its direct investors, but also the financial institutions that own them, lent them money, or did business with them. From there, the effects can ripple through the markets and impact the entire economy.

Take, for example, the June 2007 collapse of two offshore hedge funds established by Bear Stearns. Those two hedge funds were not particularly large, but were heavily invested in complex financial instruments tied to subprime mortgages. When the housing market weakened and mortgage-backed securities lost value, it wasn’t just the hedge funds that suffered losses. It was also a number of large financial institutions which had lent them money or entered into business transactions with them, including its parent company, Bear Stearns.

As Bear Stearns began reporting losses and market confidence in the firm began dropping, the Federal Reserve and Treasury Department helped broker a deal allowing JPMorgan Chase to purchase the company. As part of that deal, the government agreed to take over $30 billion in troubled assets off the books of Bear Stearns, hiring an asset manager and putting taxpayers on the hook for them financially.

But the problems didn’t stop there. Another financial institution, Merrill Lynch, had invested in the Bear Stearns hedge funds and also suffered losses. Those losses, when added to others, so damaged the company’s bottom line that, despite a promise of $10 billion in new capital from the Troubled Asset Relief Program or TARP, Merrill Lynch was viewed by the market as teetering on the brink of collapse.  With the government’s encouragement, Bank of America stepped in and bought the company. As the extent of the Merrill Lynch losses became apparent, Bank of America itself began to lose market confidence. To counteract the Merrill Lynch losses, Bank of America wound up taking billions more taxpayer dollars under the TARP Program.

In the meantime, two managers of the Bear Stearns hedge funds were arrested on charges of conspiracy, securities fraud, and wire fraud. Their cases have yet to go to trial. But prosecutors allege that as the hedge funds were losing value, their managers were telling investors a very different story. “[B]elieve it or not,” one of the financiers allegedly wrote in an e-mail to a colleague, “I’ve been able to convince people to add more money.”

The two Bear Stearns hedge funds offer a sobering set of facts, but they represent only a small part of the story. Other hedge funds are contracting or folding as clients demand their money back. To meet client demands, hedge funds are selling lots of assets, further weakening stock and bond prices. As one leading hedge fund owner, George Soros, testified before Congress in November: “It has to be recognized that hedge funds were … an integral part of the bubble which now has burst.”

Add on top of all that the Madoff scandal, and you’ve got to ask how anyone in their right mind could believe that the current regulatory exemption for hedge funds makes sense.

Four years ago, the Securities and Exchange Commission (SEC) tried on its own to beef up its regulation of hedge funds. In December 2004, the SEC issued a rule requiring hedge funds to register under the Investment Advisers Act, comply with the related regulations, and file a public disclosure form with basic information. The rule took effect on February 1, 2006, and by June 2006, over 2,500 hedge fund advisers had registered with the Commission. However, on June 23, 2006, the U.S. Court of Appeals for the District of Columbia Circuit vacated the SEC rule on the basis that it was not compatible with the Investment Advisers Act. Despite the SEC’s asserting in the case reasons why hedge funds necessitated greater federal regulation and oversight, no further effort was made by either the SEC or the Congress to step into the breach.

As SEC Commissioner Luis Aguillar stated in a speech on January 9, 2009, the SEC “currently lacks tools in the hedge fund arena to provide effective oversight and supervision.”

It is time for Congress to step into the breach and establish clear authority for federal regulation and oversight of hedge funds.

That is the backdrop for the introduction of the Grassley-Levin Hedge Fund Transparency Act. The purpose of this bill is to institute a reasonable and practical regulatory regime for hedge funds.

The bill contains four basic requirements to make hedge funds subject to SEC regulation and oversight. It requires them to register with the SEC, to file an annual disclosure form with basic information that will be made publicly available, to maintain books and records required by the SEC, and to cooperate with any SEC information request or examination.

The information to be made available to the public must include, at a minimum, the names of the companies and natural individuals who are the beneficial owners of the hedge fund and an explanation of the ownership structure; the names of any financial institutions with which the hedge fund is affiliated; the minimum investment commitment required from an investor; the total number of investors in the fund; the name of the fund’s primary accountant and broker; and the current value of the fund’s assets and assets under management. This information is similar to what was required in the disclosure form under the SEC’s 2004 regulatory effort. The bill also authorizes the SEC to require additional information it deems appropriate.

In addition, the bill directs Treasury to issue a final rule requiring hedge funds to establish anti-money laundering programs and, in particular, to guard against allowing suspect offshore funds into the U.S. financial system. The Bush Administration issued a proposed anti-money laundering rule for hedge funds seven years ago, in 2002, but never finalized it. A 2006 investigation by the Permanent Subcommittee on Investigations, which I chair, showed how two hedge funds brought millions of dollars in suspect funds into the United States, without any U.S. controls or reporting obligations, and called on a bipartisan basis for the proposed hedge fund anti-money laundering regulations to be finalized, but no action was taken. Hedge funds are the last major U.S. financial players without anti-money laundering obligations, and it is time for this unacceptable regulatory gap to be eliminated.

Our bill imposes a set of basic disclosure obligations on hedge funds and makes it clear they are subject to full SEC oversight while, at the same time, exempting them from many of the obligations that the Investment Company Act imposes on other types of investment companies, such as mutual funds that are open for investment by all members of the public. The bill imposes a more limited set of obligations on hedge funds in recognition of the fact that hedge funds do not open their doors to all members of the public, but limit themselves to investors of means. The bill also, however, gives the SEC the authority it needs to impose additional regulatory obligations and exercise the level of oversight it sees fit over hedge funds to protect investors, other financial institutions, and the U.S. financial system as a whole.

The bill imposes these requirements on all entities that rely on Sections 80a-3(c)(1) or (7) to avoid compliance with the full set of the Investment Company Act requirements. A wide variety of entities invoke those sections to avoid those requirements and SEC oversight, and they refer to themselves by a wide variety of terms – hedge funds, private equity funds, venture capitalists, small investment banks, and so forth. Rather than attempt a futile exercise of trying to define the specific set of companies covered by the bill and thereby invite future claims by parties that they are outside the definitions and thus outside the SEC’s authority, the bill applies to any investment company that has at least $50 million in assets or assets under its management and relies on Sections 80a-3(1) or (7) to avoid compliance with the full set of Investment Company Act requirements. Instead, those companies under the bill have to comply with a reduced set of obligations, which include filing an annual public disclosure form, maintaining books and records specified by the SEC, and cooperating with any SEC information request or examination.

Finally, our bill makes an important technical change. It moves paragraphs (c)(1) and (7) – the two paragraphs that hedge companies use to avoid complying with the full set of Investment Act Company requirements — from Section 80a-3 to Section 80a-6 of the Investment Company Act. While our bill preserves both paragraphs and makes no substantive changes to them, it moves them from the part of the bill that defines “investment company” to the part of the bill that exempts certain investment companies from the Investment Company Act’s full set of requirements.

The bill makes this technical change to make it clear that hedge funds really are investment companies, and they are not excluded from the coverage of the Investment Company Act. Instead, they are being given an exemption from many of that law’s requirements, because they are investment companies which have voluntarily limited themselves to one hundred or fewer beneficial owners and to accepting funds only from investors of means. Under current law, the two paragraphs allow hedge funds to claim they are excluded from the Investment Company Act – they are not investment companies at all and are outside the SEC’s reach. Under our bill, the hedge funds would qualify as investment companies – which they plainly are — but would qualify for exemptions from many of the Act’s requirements by meeting certain criteria.

It is time to bring hedge funds under the federal regulatory umbrella. With their massive investments, entanglements with U.S. banks, securities firms, pension funds, and other large investors, and their potential impact on market equilibrium, we cannot afford to allow these financial heavyweights to continue to operate free of government regulation and oversight.

When asked at a recent hearing of the Senate Homeland Security and Government Affairs Committee whether hedge funds should be regulated, two expert witnesses gave the exact same one-word answer: “Yes.” One law professor, after noting that disclosure requirements don’t apply to hedge funds, told the Committee: “[I]f you asked a regulator what … role did hedge funds play in the current financial crisis, I think they would look at you like a deer in the headlights, because we just don’t know.” It is essential that federal financial regulators know what hedge funds are doing and that they have the authority to prevent missteps and misconduct.

The “Hedge Fund Transparency Act” will protect investors, and it will help protect our financial system. I hope our colleagues will join us in support of this bill and its inclusion in the regulatory reform efforts that Congress will be undertaking later this year.

Geithner Testimony – Consider Regulation of Hedge Funds

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Nominee Calls for More Financial Regulations

Treasury Secretary nominee Timothy Geithner testified before the Senate Finance Committee on January 21, 2009.  In prepared remarks Geithner hints at a desire to increase regulation of the financial markets:

I believe that markets are central to innovation and to growth, but that markets alone cannot solve all problems. Well-designed financial regulations with strong enforcement are absolutely critical to protecting the integrity of our economy.

During the testimony Geithner faced pointed questions regarding tax policies and the failure of the current regulatory regime to effectively police the financial markets.  Many times he stated that increased regulation may be necessary to protect all participants within the financial markets.  Specifically with regard to hedge funds, in his answer to a question posed by Senator Grassley, Geithner stated “I believe that we should consider requiring registration of hedge funds.” Continue reading →