Category Archives: News and Commentary

Obama Moves Forward with Hedge Fund Registration Legislation

Bart Mallon, Esq.
http://www.hedgefundlawblog.com

Treasury Announces New “Private Fund Investment Advisers Registration Act of 2009”

After much discussion in the press over the last 8 to 10 months abut the possibility for hedge fund registration, the Treasury today announced the Obama Administration’s bill which requires managers to “private funds” to register with the SEC.  This registration requirement would apply to managers of all funds relying on the Section 3(c)(1) or Section 3(c)(7) which includes managers to private equity and venture capital funds.  Additionally, all registered managers would need to provide the SEC with certain reports on the funds which they manage.

The Treasury release is below and can be found here.  We will post the text of the new act shortly.  [Update: we have just published the text of the Private Fund Investment Advisers Registration Act of 2009.]

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Fact Sheet: Administration’s Regulatory Reform Agenda Moves Forward: Legislation for the Registration of Hedge Funds Delivered to Capitol Hill

Continuing its push to establish new rules of the road and make the financial system more fair across the board, the Administration today delivered proposed legislation to Capitol Hill to require all advisers to hedge funds and other private pools of capital, including private equity and venture capital funds, to register with the Securities and Exchange Commission (SEC). In recent years, the United States has seen explosive growth in a variety of privately-owned investment funds, including hedge funds, private equity funds, and venture capital funds. At various points in the financial crisis, de-leveraging by such funds contributed to the strain on financial markets.  Because these funds were not required to register with regulators, the government lacked the reliable, comprehensive data necessary to monitor funds’ activity and assess potential risks in the market.  The Administration’s legislation would help protect investors from fraud and abuse, provide increased transparency, and provide the information necessary to assess whether risks in the aggregate or risks in any particular fund pose a threat to our overall financial stability.

Protect Investors From Fraud And Abuse

Require Advisers To Private Investment Funds to Register With The SEC.  Although some advisers to hedge funds and other private investment funds are required to register with the Commodity Futures Trading Commission (CFTC), and some register voluntarily with the SEC, current law generally does not require private fund advisers to register with any federal financial regulator. The Administration’s legislation would, for the first time, require that all investment advisers with more than $30 million of assets under management to register with the SEC.  Once registered with the SEC, investment advisers to private funds will be subject to important requirements such as:

  • Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
  • Disclosure requirements to investors, creditors, and counterparties of their advised private funds
  • Strong conflict-of-interest and anti-fraud prohibitions
  • Robust SEC examination and enforcement authority and recordkeeping requirements
  • Requirements to establish a comprehensive compliance program

Require Increased Disclosure Requirements. The Administration’s legislation would require that all investment funds advised by an SEC-registered investment adviser be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements.

Protect Financial System From Systemic Risk

Monitor Hedge Funds For Potential Systemic Risk. Under the Administration’s legislation, the regulatory requirements mentioned above would include confidential reporting of amount of assets under management, borrowings, off-balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other important information relevant to determining potential systemic risk and potential threats to our overall financial stability. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk. In addition, the SEC would share the disclosure reports received from funds with the Federal Reserve and the Financial Services Oversight Council. This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to our overall financial stability and should therefore be supervised and regulated as Tier 1 Financial Holding Companies.

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions.  If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510.  Other related hedge fund law articles include:

Hedge Fund Compliance and Twitter

Cat and Mouse Securities Compliance

It seems so many aspects of the securities industry is the cat and mouse game of regulate (government) and sneakily avoid (industry participants).  This is especially true when it comes to compliance and “what you can get away with.”  As the post below notes, many compliance rules (and other securities laws and regulations) are written fairly broadly – accordingly, registered individuals always need to be aware of the consequences of their actions.  The article reprinted below by Doug Cornelius of the Compliance Building blog examines the misconceptions of Twitter and compliance requirements.
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Twitter and Compliance

By Doug Cornelius

I was struck recently by the power and misconceptions around Twitter, the current press darling of Web 2.0. On one side is the enormous power of Twitter to crowdsource the news. The fallout of the Iran elections was better covered on Twitter than the mainstream media. At one point I watched CNN only to see the anchors reading from Twitter and displaying images posted to Twitter applications.

On the other side is the misconception that Twitter communications are not regulated by the SEC or FINRA. Everyone can acknowledge that the regulations have not caught up with the current tools of web 2.0. But the existing rules were drafted broad enough to cover all electronic communication. Twitter is clearly electronic communication.

Last week at at Jeff Pulver’s 140 Characters Conference in New York an attendee said “Twitter allows us to say f— you to the SEC!”  Earlier this week there was a quote in Forbes.com that “Since brokers have to save instant messages and e-mail, but thus far have no such mandate for tweets….”

The SEC and FINRA may have more pressing issues on its hands, but the existing rules cover the use of Twitter. Sure the rules could be more explicit. But ignore them at your peril.

If you are a registered representative, you should take a look at FINRA’s Guide to the Internet.  The features of Twitter could be considered an advertisement, sales literature, or correspondence. The direct message feature is correspondence. If your Twitter feed is unprotected, each twitter post would be considered an advertisement. If your Twitter feed is protected it would be considered sales literature.

The SEC’s Guidance on the use of web sites (SEC Release 34-58288) does not give the clearest guidance. But it is clear that the rules are independent of the platform and the technology.

Insider trading, wrongful public disclosure and fraud and prohibited regardless of the communication tool. That includes Twitter.

Companies that have to monitor electronic communications should add Twitter to the mix. As the Iran election showed us, blocking access is ineffective. You should adopt a policy for Twitter or a revise your existing policies to specifically include it.  Twitter has become too popular and powerful as a tool to ignore.

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Please feel free to leave us a comment below on this article.  You can also contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Obama Administration Proposes New Regulatory Agency

Assistant Secretary Michael Barr Testifies Before House Committee Regarding President’s Proposal to Establish New Consumer Financial Protection Agency

On July 8th, 2009, Assistant Secretary Michael Barr delivered a statement before the House Committee on Energy and Commerce regarding the Administration’s recent proposal to establish a new financial regulatory agency designated with the sole task of protecting consumers across the financial services industry.   Per the proposal, the new Consumer Financial Protection Agency will set consistently high standards for financial service providers to protect consumers from abuse.  In his statement, Barr points out that the current system for consumer protection is inherently flawed due to various inadequacies, including the lack of unified leadership, federal supervision, and an enforceable system for accountability. He also cites that the root cause of these various setbacks is a ‘fragmented regulation’, in which one agency was responsible for enacting regulations while another agency was responsible for enforcement.  With a new singular agency in the marketplace dedicated to protecting consumers against regulatory arbitrage, the financial industry will once again be restored with the confidence and protections necessary to hopefully make regulatory arbitrate a thing of the past.

Consumer Financial Protection Agency Act of 2009, a part of Obama’s new financial regulation plan, details the Administration’s initiative to create the new dedicated agency.  President Obama’s statement with regard to this new agency can be found here.

The full text of the related press release on this matter is reprinted below.

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July 8, 2009

Assistant Secretary for Financial Institutions Michael Barr before the House Committee on Energy and Commerce Subcommittee on Commerce, Trade, and Consumer Protection

Opening Statement – As Prepared for Delivery

Thank you, Chairman Rush and Ranking Member Radanovich, for providing me with this opportunity to testify about the Administration’s proposal to establish a new, strong financial regulatory agency charged with just one job: looking out for consumers across the financial services landscape.  Last week, the Administration sent legislative language to Congress to create the new agency, and in the coming weeks, we will continue to transmit legislation to implement other core proposals to strengthen regulation of financial institutions and markets and lay the foundation for a safer, more stable financial system.

As Secretary Geithner has said, protecting consumers is important in its own right and also central to safeguarding the system as a whole.  We must restore honesty and integrity to our financial system, in order to restore trust and confidence.  A key step to doing so is to establish clear federal accountability for protecting consumers and the authority necessary to carry out the job.

That is why the President is proposing the Consumer Financial Protection Agency.

We will have one agency for one marketplace with one mission – to protect consumers.  It will have the authority and resources it needs to set consistently high standards and a level playing field across the financial services sector–for banks and non-bank financial services providers alike.  Its market-wide jurisdiction will put an end to regulatory arbitrage and unregulated corners that inevitably weaken standards across the board.  Structures and mechanisms in our legislation will ensure the agency remains accountable for its mission, yet independent.  The Agency could choose from a wide range of tools to promote transparency, simplicity, and fairness.  The breadth and diversity of these tools will enable it to adopt the most effective and proportionate, and least costly, approach to any problem.  It will have the tools and resources to maintain expertise, and the incentives to act in a balanced manner that protects consumers from abuse while ensuring their access to innovative, responsible financial services.  At the same time, the Federal Trade Commission would retain key powers and gain new ones, including streamlined rulemaking procedures and heightened penalties for violations.

The Current System for Consumer Financial Protection Regulation is Fundamentally Flawed

A dedicated consumer protection agency for financial services is the only effective response to inherent weaknesses in our existing oversight regime.  The financial crisis revealed the alarming failure of this regime to protect responsible consumers – and keep the playing field level for responsible providers.  The federal government has failed in its most basic regulatory responsibility: to protect consumers.  And no provider should be forced to choose between keeping market share and treating consumers fairly.  The states do their best with limited resources but they look to the federal government for leadership, and there is no federal agency with the structure and authority to lead.

Instead of leadership and accountability, there is a fragmented system of regulation designed for failure.  Bank and non-bank financial service providers often compete vigorously in the same consumer markets but are subject to two different and uncoordinated federal regimes – one based on examinations and supervision, the other based on after-the-fact investigations and enforcement actions.  The lack of federal supervision of non-bank providers is an open invitation to the less responsible actors that seek darker corners to ply their dubious practices.  These actors are willing to gamble that the FTC and state agencies lack the resources to detect and investigate them.  This puts enormous pressure on banks, thrifts, and credit unions to lower their standards to compete – and on their regulators to let them.  Fragmentation of the supervision of banks and thrifts only makes this problem worse: a banking institution can choose the least restrictive among several different supervisory agencies.  Despite best intentions, “regulatory arbitrage” inevitably weakens protections for consumers and feeds bad practices.

This is precisely what happened in the mortgage market.  Independent mortgage companies and brokers grew apace with little oversight.  They peddled subprime and exotic mortgages – such as “option ARMs” with exploding payments and rising loan balances – in misleading ways to consumers least able to handle their complex terms and hidden, costly features.  The FTC and the states took enforcement actions, but their resources were no match for rapid market growth, and they could not set rules of the road for the whole industry or supervise institutions to prevent bad practices from spreading.  To compete over time, banks and thrifts and their affiliates came to offer the same risky products as their less regulated competitors and relaxed their standards for underwriting and sales.  Lenders of all types paid their mortgage brokers and loan officers more to bring in riskier and higher-priced loans, with predictable results.  Bank regulators were slow to recognize these problems, and even slower to act.  The consequences for homeowners were devastating, and our economy is still paying the price.

Our system allowed this to take place even entirely within the highly-regulated, closely-supervised world of banks and thrifts.  Take credit cards.  Some banks found they could boost fee and interest income with complex and opaque terms and features that most consumers would not notice or understand.  These tricks enabled banks to advertise seductively low annual percentage rates and grab market share.  Other banks found they could not compete if they offered fair credit cards with more transparent pricing.  So consumers got retroactive rate hikes, rate hikes without notice, and low-rate balance transfer offers that trapped them in high-rate purchase balances.  A major culprit, once again, was fragmented regulation: one agency held the pen on regulations, another supervised most of the major card issuers.  Each looked to the other to act, and neither acted until public outrage reached a crescendo.

The list goes on.  A wide range of credit products are offered–from payday loans to pawn shops, to auto loans and car title loans, many from large national chains–with little supervision or enforcement.  Closely regulated credit unions and community banks with straightforward credit products struggle to compete with  less scrupulous providers who appear to offer a good deal and then pull a switch on the consumer.   For instance, overdraft policies are a form of credit but are not disclosed or regulated as such.

The problem with our system is not just the gaps and overlaps between regulators.  Our federal agencies do not have missions, structures, and authorities suited to effective consumer protection in financial markets.  The FTC has a broad mission to protect consumers in all markets, of which the financial services market is just one; and it has no jurisdiction over banks.   The agency has brought important cases against some of the worst financial abusers, but these cases often take a long time and the damage is already done.  The agency does not have the supervisory and examination authority or expertise needed to detect and prevent problems before they spread throughout the market.

Bank regulators have supervisory powers over banks, but their primary mission is to ensure banks are safe and sound, not to protect consumers.  Consumer supervision does not fit comfortably within these agencies, and it will never share the front seat with safety and soundness.  Too often, consumer compliance supervision focused on “checking boxes” – is the annual percentage rate on this loan calculated as prescribed?  Is it displayed with a large enough type size?  That often meant missing the forest for the trees.

It was thought that supervising the banks for their effective management of “reputation risk” and “litigation risk” – aspects of a safe and sound institution — would ensure the banks treated their customers fairly.  It didn’t.  It did not prevent our major banks and thrifts from retroactively raising rates on credit cards as a matter of policy, or from selling exploding mortgages to unwitting consumers as a business expansion plan.  Managing a bank’s reputation and litigation risk does not and cannot protect consumers because this approach judges a bank’s conduct toward consumers by its effect on the bank, not its effect on consumers.

We Need One Agency for One Marketplace with One Mission – to Protect Consumers – and the Authority to Achieve It

Tinkering with the consumer protection mandates or authorities of our existing agencies cannot solve the fundamental problem that they are organizationally ill-designed to protect consumers, and too fragmented to maintain high and consistent standards across the consumer financial marketplace.  There is only one solution that can work.  We need one agency for one marketplace with one mission – to protect consumers of financial products and services – and the authority to achieve that mission.  A new agency with a focused mission, comprehensive jurisdiction, and broad authorities is also the only way to ensure consumers and providers high and consistent standards and a level playing field across the whole marketplace without regard to the form of a product – or the type of its provider.

That is the agency we are proposing to create.  The CFPA will have the sole mission of protecting consumers; it will be the agency that sees the world through their eyes.  It will write regulations, supervise institutions and providers for compliance, and lead enforcement efforts – for the whole marketplace.  The implications of our proposal for consumer protection and fair competition are enormous.  It will bring higher and more consistent standards; stronger, faster responses to problems; the end of regulatory arbitrage; a more level playing field for all providers; and more efficient regulation.

Let me start with rule writing.  The CFPA will be able to write rules for all consumer financial services and products and anyone who provides these products.  It will assume existing statutory authorities – such as the Truth in Lending Act and Equal Credit Opportunity Act.  New authorities we propose – to require transparent disclosure, promote simple choices, and ensure fair terms and conditions and fair dealing – will enable the agency to fill gaps as markets change and to provide strong and consistent regulation across all types of consumer financial service providers.

For example, our proposal gives the CFPA the power to strengthen mortgage regulation by requiring lenders and brokers to clearly disclose major product risks, and offer simple, transparent products if they decide to offer exotic, complex products.  The CFPA will also be able to impose duties on salespeople and mortgage brokers to offer appropriate loans and meet a duty of best execution, and prevent lenders from paying “yield spread premiums” that pay brokers more if they deliver loans with higher rates than consumers qualify for.  Lenders and consumers would finally have an integrated mortgage disclosure: the CFPA will continue the work of the Federal Reserve and the Department of Housing and Urban Development to create and maintain a single, federal mortgage disclosure.

Comprehensive rule writing authority would improve other markets, too.   For example, the CFPA could adopt consistent regulations for short-term loans – establishing disclosure requirements and banning unfair practices – whether these loans come in the form of bank overdraft protection plans or payday loans or  car title loans from non-bank providers.  The agency also could adopt standards for licensing and monitoring check cashers and pawn brokers.

Combining these robust rule writing authorities with supervision and enforcement authorities in one agency will ensure faster and more effective rules.  For example, the CFPA will both implement the new Credit CARD Act of 2009 – to ban retroactive rate hikes and rate hikes without notice – and will supervise the credit card banks for compliance.  So the agency will have a feedback loop from the examiners of the banks to the staff who write the regulations, allowing staff to determine quickly how well the regulations are working in practice and whether they need to be tightened or adjusted.  That feedback loop is broken today because rule writing and supervision are divided between two agencies.  Consolidated supervisory authority would also allow faster action on mortgages to prevent irresponsible practices that undermine responsible lenders.  It took the federal banking agencies two years to reach final consensus on supervisory guidance on option ARMs and subprime mortgages after evidence of declining underwriting standards emerged publicly.  A single agency could act within months and save many more consumers and communities from significant harm.

Our proposal for comprehensive jurisdiction will also make regulatory arbitrage a thing of the past.  Providers will not have a choice of regulators.  So, by definition, they will not be able to choose a less restrictive regulator.  The CFPA will not have to fear losing “market share” because our legislation gives it authority over the whole market.  Ending arbitrage will prevent the vicious cycles that weaken standards across the market.

Consolidating consumer protection in an agency with comprehensive jurisdiction will also protect consumers no matter with whom they do business, and level the playing field for all institutions and providers.  Consumers do not care what legal form their service provider takes; nor should they.  A short-term loan can be made by a bank, a bank affiliate, a finance company, or a payday lender.  The CFPA could apply to non-bank providers the tools of supervision that regulators now apply to banks – including setting compliance standards, conducting compliance examinations, reviewing files, obtaining data, issuing supervisory guidance and entering into consent decrees or formal orders.  The CFPA would have the ability to send examiners into the large, fast-growing independent mortgage companies that caused most of the damage during the mortgage boom to review loan files and interview salespeople.  With these tools, the Agency would be able to identify problems before they spread, stop them before they cause serious injury, and relieve pressures on responsible providers to lower their standards.

The CFPA is not a new layer of regulation; it will consolidate existing regulators and authorities.  This will bring efficiencies for industry.  It will have a clear address for concerns about regulatory burden, and it can expect speedier responses to legitimate claims of unwarranted burdens.  Moreover, responsible industry actors will worry less about unfair competition from irresponsible actors, since all providers will be under this agency’s jurisdiction.

Of course, even with a strong supervisory and enforcement staff, no agency can oversee tens of thousands of financial service providers on its own.  The FTC and the states will continue to play critical roles.  The FTC will retain authority to investigate and prosecute financial-related frauds under its FTC Act authority to prevent unfair or deceptive practices.  The states will continue to license and bond non-bank service providers, with authority for the CFPA to set strong new federal standards and directly and forcefully to act, by sending in supervisors and examiners when risks are warranted.  The CFPA will be able to coordinate closely with the FTC and the states to share information and shore up weaknesses.

The CFPA Will be Held Accountable While Remaining Independent

The public deserves accountability for consumer protection, and creating the CFPA will, finally, give them that accountability.  Consumers and their elected representatives will have a place to bring their consumer protection concerns, and one agency to hold accountable for results.  Clear accountability will, therefore, produce better results.

Our legislation contains specific measures to help ensure better regulation and prevent agency inertia or backsliding.  The CFPA will maintain a unit to analyze consumer complaints across the full range of providers – banks and non-banks – and markets.  Its analysis will be published annually.  The agency also will maintain a research unit to track changes in markets, products, and consumer behavior and assess risks to consumers – and their understanding of these risks.  The agency will give particular consideration to monitoring fast-growing providers and products – such as independent mortgage companies and subprime loans during the housing boom – where risks are often higher.  The CFPA will publish significant findings of these monitoring activities at least once each year, and report annually to Congress on its regulatory, enforcement, and supervisory activities.

Accountability must be balanced with independence.  The agency will have a stable funding stream in the form of  appropriations and fee assessments akin to those regulators impose today.  Stable funding is a necessary, but not sufficient, ingredient for true independence.  Sustained independence also depends on expertise and respect.  The agency will be able to hire a top notch and diversified staff.  Our legislation would provide the agency’s attorneys, economists, finance experts, examiners, and other professionals the same salaries on average as professionals of the banking agencies.  The agency would absorb the banking agencies’ teams of consumer compliance examiners, and hire and train new examiners for non-bank providers.

The CFPA Will Be  Effective Because it will be Expert, and its Actions Will be Balanced and Proportionate

We are proposing the CFPA be given broad authorities.  Our legislation is designed to ensure the agency uses these authorities effectively and with expertise, balance, and proportion – qualities that will ensure the agency remains effective and independent.

Deep and sophisticated understanding.  Our legislation assures the CFPA will have the deep understanding of consumers, providers, and products it will need to write rules that are effective, balanced, and proportional.   As mentioned above, a research unit, consumer surveys and testing, complaint tracking and compliance examiners will help ensure that the CFPA is up-to-date with developments in the market.  As they do today, examiners for the largest and most complex institutions, whether banks or non-banks, will reside on-site so they fully understand products and operations.  These mechanisms will provide the agency critical information to craft effective, tailored regulations that do not impose unnecessary costs, and to determine when regulations should be expanded, modified, or eliminated.

Balanced regulations.  When it adopts and reviews regulations, the agency will be required to balance a range of competing objectives.  Its four-fold mission includes (1) protecting consumers from abusive or unfair practices; (2) ensuring that they have the information they need to make responsible choices; (3) ensuring markets are efficient and have ample room for innovation, and (4) promoting access to financial services.  The CFPA will have to balance these potentially competing goals.  Our legislation also explicitly requires the CFPA to consider the costs, not just the benefits, of regulations to consumers and financial institutions – including any potential reduction in consumers’ access to financial services.  Moreover, the agency will be able to adopt appropriate exemptions from its rules for providers or products where necessary to fulfill the four objectives.  Once it adopts a major regulation, the agency will have to review it within five years to make sure it remains consistent with these objectives

Flexible approaches and tailored solutions.  Comprehensive authority over the whole market will give the agency a range of options for setting standards so it can choose the most effective, least-cost option.  When flexibility is at a premium, the agency can issue supervisory guidance and use examination reports and other techniques to foster change.  Today, supervisory guidance usually must be agreed to by four or more federal agencies and fifty states, which causes considerable delays and dilutes effectiveness.  One agency for one market will make guidance a much more effective tool than it is today.  When a stricter approach is appropriate, the agency can adopt regulations and impose penalties for violations.

Moreover, diverse rule writing authorities will ensure the agency can tailor its regulations to the underlying problem with the least cost to consumers and institutions.  The agency will have ample authority to harness the benefits of market discipline by improving the quality of, and access to, information in the marketplace.  For example, it will have authority for principles-based, non-technical standards to ensure marketing materials and sales pitches are reasonable and include clear disclosure of product risks in balance with advertised benefits.  We have included authority for the agency to permit providers to pilot new disclosure approaches.  The agency will also be able to adopt new, more concrete disclosures that highlight for consumers the consequences of their decisions – akin to the minimum payment warning on credit card periodic statements under the Credit CARD Act of 2009.  Consumers, themselves, will be able to access their financial information in a usable, electronic format so they can conduct their own assessments of decisions they have made or are planning to make.  Increasing the quality and accessibility of product information will make it easier for consumers and providers alike to understand the marketplace and make better choices.

The agency will also be able to encourage providers to offer simple products to help comparison shopping.  For example, providers that offer exotic, complex, and riskier products would need to offer at least one standard, simple, less risky product.  In the mortgage market, a lender or broker that peddles mortgages with potentially exploding monthly payments, hidden fees and prepayment penalties, and growing loan balances – such as the “pay option ARMs” of recent years – might also be required to offer consumers 30-year, fixed-rate mortgages or ARMs with straightforward terms.  The point is to make it easier for consumers to choose simpler products, which should limit the need for costlier restrictions on terms and practices.

The agency will also have the ability to align incentives, which can sometimes be more effective than outlawing particular terms or practices and chasing down the inevitable circumventions.  It will have authority to impose duties on frontline salespeople and middle men and regulate the form, manner, or timing – but not amount – of their compensation as needed to promote fair dealing.  If they give financial advice and consumers reasonably rely on it, the agency will be able to ensure their advice meets a minimum standard of care.  The agency will also be able to ensure salespeople and middle men are not paid more to take advantage of consumers’ trust or inexperience.  For example, the agency might decide to prohibit mortgage lenders from paying salespeople or brokers higher bonuses for delivering loans with higher interest rates than borrowers qualify for, with hidden costly fees, since this creates a perverse incentive to mislead consumers into taking out costlier loans.

With a broad range of supervisory and regulatory tools, the agency will be able to choose the most effective, least costly solution for each problem.  Let me give you an example of how this might work.  In response to the strong protections of the Credit CARD Act of 2009, credit card issuers will substantially change their terms and practices.  New terms or practices may raise new questions of fairness.  If that happens, the CFPA will be able to proceed deliberately and in stages.  For example, it could begin by asking card issuers to produce evidence that consumers understand the new terms or practices and can avoid the risks they pose.  If this evidence seems inadequate, the agency could conduct its own testing with consumers.  If this testing showed widespread lack of consumer understanding, the agency could consider a range of options, from improving disclosure to providing stronger incentives to offer simpler products to further restricting unfair terms and practices.

Respect for safety and soundness.  When it uses these authorities, the CFPA will respect the safety-and-soundness imperatives of bank regulation.  When conflicts do arise, structures for compromise will facilitate resolution. A safety and soundness regulator will have one of five board seats, and the agency must consult with safety and soundness regulators before adopting rules.  In addition, the CFPA can work with the banking agencies to ensure bank consumer compliance examiners are trained to understand safety and soundness, as they are today.

In short, the comprehensive authority we propose will not increase regulatory burden or lead to unreasonable regulations.  It will do the opposite.  It will ensure the agency has a deep understanding of products and providers.  And it will enable the agency to choose from among a wide range of tools and authorities to find the most effective, least-cost solution.  This will save consumers – and financial service providers – significant costs over the long term.

Our Legislation Will Respect and Strengthen the Core Functions of the Federal Trade Commission

Our legislation does not affect the jurisdiction of the FTC over the vast array of non-financial markets and actually strengthens its ability to police those markets.  To increase the FTC’s ability to protect consumers, we propose that the FTC be able to (1) adopt rules to prohibit unfair or deceptive acts or practices with standard notice-and-comment rulemaking; (2) obtain civil penalties when companies use unfair or deceptive practices; and (3) pursue those who substantially aid and abet providers that commit unfair or deceptive practices.  The Administration also supports increased resources in the 2010 President’s Budget for the FTC so that consumers can be better protected across all markets.

As for financial markets, the FTC will continue to have authority under the FTC Act to pursue financial fraud without delay, including foreclosure rescue and loan modification scams.  The  FTC would simply be required to consult and coordinate with – but not refer these cases to – the CFPA.  The CFPA would also have authority under the proposed legislation to pursue fraud and deceptive practices by financial service providers.  The consultation requirement ensures there will be coordination, much like the coordination that occurs informally between the states and the FTC today in pursuing fraud.  The FTC will also retain authority for writing rules under the Telemarketing Sales Act and concurrent responsibility for enforcing them over financial products and services.

The CFPA will have substantial authority over mortgages under other statutes, so it will assume the rulemaking authority recently granted to the FTC over mortgage loans.  This assures consumers and providers a consistent and consolidated approach to regulating mortgages throughout the whole life of the loan, from sale and origination to payoff, modification, or foreclosure.

With respect to rules or statutes other than the FTC Act, the FTC will have “backstop” authority to enforce the same consumer credit statutes that it can enforce now.  Under that authority, if the FTC – or a bank regulator – becomes aware of a possible law violation of those statutes, it may send a written recommendation that the CFPA take action, stating its concerns, and proceed itself on the matter after 120 days if the CFPA does not take action.  The Administration is proposing to apply the same referral requirement to the bank regulators.  This requirement will help ensure a consistent federal approach to interpreting and enforcing consumer protection statutes such as the Truth in Lending Act, while leaving the FTC and the banking agencies the ability to act if the CFPA does not.  The approach is flexible enough to permit the agencies to agree to practical arrangements for referrals and appropriate use of the FTC’s backstop authority.

The FTC would retain primary authority in the area of data security for nonbank entities.  It would continue its current role of enforcing, as to nonbank financial service providers, Section 5 of the FTC Act as it applies to  data security practices and its Safeguards Rule, which implements Section 501(b) of the Gramm-Leach- Bliley Act. [1][1]  Consistent with the CFPA’s exclusive authority over consumer disclosure in other areas, however, the CFPA would have primary authority under the “front end” privacy provisions of GLBA (e.g. privacy notice and related provisions) for all financial institutions (banks and nonbanks), and as well as its own authority under the proposed legislation that parallels Section 5 of the FTC Act.

Conclusion

Our proposal will ensure the financial regulator community includes one agency with the single mission of protecting consumers.  It is time to put consumer protection responsibility in an agency with a focused mission and comprehensive jurisdiction over all financial services providers, banks and non-banks.  It is time for a level playing field for financial services competition based on strong rules, not based on exploiting consumer confusion.  It is time for an agency that consumers – and their elected representatives – can hold fully accountable.  And it is long past time for a stronger FTC.  The Administration’s legislation fulfills these needs.  Thank you for this opportunity to discuss our proposal, and I will be happy to answer any questions.

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Notes:
[1] Because of its relationship to data security, the FTC would also retain its rulemaking and enforcement authority for the Red Flags Rule under Section 615(e) and the Disposal Rule under Section 628 of the FCRA.   The remainder of rulemaking and enforcement authority under the FCRA would transfer to the CFPA.
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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Hedge Funds and Investors: June 2009

Overview of the Hedge Fund Industry in June

It is nice to have a chance to step back from the regulatory side to see the big picture of the hedge fund industry.  The article below discusses what is currently happening in the various hedge fund strategies and what investors are looking for from managers.  The article is written by Bryan Goh (First Avenue Partners) and addresses the issues related to the hedge fund industry in June of 2009.  Reprinted from Byan’s blog called Ten Seconds Into the Future.
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Hedge Funds: The State of the Craft: June 2009

By Bryan Goh

The fundamental picture:

The second quarter of 2009 witnessed a continuation of the rally in all risky assets from equities to credit to commodities and energy to illiquid Asian physical real estate. On the back of this reversal of the acute risk aversion that plagued the fourth quarter of 2008 and the first quarter of 2009, economists began to detect ‘green shoots’ of economic recovery. However, economic growth forecasts in the developed world continue to be depressed. The US for example is expected to show -2.8% growth in 2009 with a weak recovery in 2010 of 1.6%; the Euro zone is expected to shrink by 2.3% in 2009 and grow by an insipid 1.7% in 2010 with dire numbers from Germany (-5.5% 2009, +0.55% 2010), and Italy (-4.4% 2009, +0.4 2010). Emerging markets were widely expected to decouple, but thus far the incipient recovery is only evident in BRIC, with China growing +6.5% in 2009 and +7.3% in 2010, India growing +5.5% in 2009 and +6.4% in 2010, Brazil shrinking 1.5% in 2009 before growing 2.7% in 2010 and Russia shrinking 5% in 2009 and growing 2% in 2010. Outside of the BRIC, emerging markets’ highly export driven economies are severely impacted by the slowdown in the developed world,  the dearth of demand and the unavailability of trade finance.

Developed markets have been hobbled with historically high debt levels, distressed real estate prices, rising unemployment, weakening retail sales, shrinking industrial production and declining consumer and business confidence. Coupled with impaired sovereign balance sheets, the result of financial rescue packages, Keynesian fiscal reflationary policies, an ageing population’s impact on state pensions and healthcare, the outlook for developed market growth is not optimistic. The one area of potential respite is the external sector, which as a matter of mathematics has to and will adjust to reduce the scale of current account imbalances.

Emerging markets have somewhat healthier financial systems, sovereign balance sheets and private savings levels and are thus in a better position to implement fiscal reflationary policies and centrally influenced if not planned extension and allocation of credit. This, however, remains concentrated in the larger emerging markets such as BRIC where domestic diversification reduces the dependence on the external sector.

The expansion of the government in the economy is therefore more feasible in the BRIC. It has been moderately successful. China is a case in point where fixed capital formation in the form of infrastructure build has more than made up for the gap from a collapse of external trade and a moribund consumer sector.

These efforts provide a stay of execution. Time, however, is a healer, under the assumption of free markets. Protectionism and outright central planning has historically proven counter productive. It is interesting to note that while developed markets flirt with market interventionist policies, bend Chapter 11, and increasingly embrace quantitative easing, further emergency interest rate policy, flirting with protectionism, interfering with the banking system; emerging markets have by and large embraced free markets.

While policy makers continue to hold interest rates at low levels, the inflation deflation debate continues. Central banks with formal inflation targets may be more likely to tighten prematurely than central banks with a softer target or a more holistic mandate. Given the rate at which capacity utilization has fallen and the current levels at which it rests, it is unlikely that inflation will take hold. On the other hand, given the reflationary capacity of BRIC and competition for natural resources, deflation is unlikely to take hold either. Central banks are likely to be afforded the latitude to hold short rates lower for longer in their anti-recessionary campaigns. Long bond yields are likely to display news driven and data driven volatility as signs of inflation wax and wane.

Hedge Fund Performance:

Performance to May 2009:

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Hedge Fund Outlook:

Generally, the outlook for hedge fund strategies is very positive. There are a number of reasons for this. The period 2005 to 2007 saw a surge in equity capital employed in hedge fund strategies. With increasing volumes of arbitrage capital, return on gross capital employed compressed, as one would naturally expect. Hedge funds adaptively increased their leverage in order to maintain return on equity, a strategy feasible because interest rates were low and credit spreads were tight and thus leverage was cheap. The bankruptcy of Bear Stearns and then Lehman Brothers in 2008, triggered a massive deleveraging of the entire arbitrage industry from hedge funds to bank proprietary trading desks. Mark to market losses triggered large scale redemptions from hedge funds which left what in 2007 was a 2 trillion USD industry with an estimated paltry 1.2 trillion USD of assets under management. This together with the wholesale withdrawal of leverage from an average of 3.5 to 4 X to 1.5 to 2X, implies a 70% to 75% shrinkage in capital employed in arbitrage. The indiscriminate withdrawal of risk has created ubiquitous arbitrage and relative value opportunities.

Equities: Market sentiment went from monotonic risk aversion from the second half of 2009 into the first quarter of 2009. During this time, equity dispersion was explained not by earnings prospects but by news flow and macro implications on balance sheet integrity. And a great deal of simple panic. The very sharp rebound from mid March 2009 has similarly been driven not by earnings fundamentals but by a reversal of risk aversion and other dynamic factors. As market volatility settles, equity dispersion is expected to be increasingly driven by fundamentals once again. The opportunity set for equity long short managers is improved.

Event driven: In every distressed cycle, private equity buyouts dwindle and deal break risk is escalated due to buyers remorse. When coupled with a credit crisis, jurisdictions where committed financing is not a prerequisite to an approach and banks themselves in jeopardy also increase deal risk. Following this initial round of panic and disorder, the following period of calm usually witnesses deal flow on the basis of strategic alliance, self preservation, consolidation, asset disposals, and capital raising. This is the landscape facing the event driven merger arbitrageur today. The dearth of arbitrage capital has also resulted in slower convergence, more volatility of spread and a profitable environment for the strategy.

Macro and Fixed Income: Macro strategies did relatively well in 2008 as large and trivial trades presented themselves with the ebb and flow of capital driven by acute risk aversion and government reactionary policy. These trades have now receded into history. Going forward macro is likely to continue to perform well on the back of persistent volatility in fixed income markets driven by the cycles of central bank policy and investor prevarication between inflation and deflation. These same themes create interesting arbitrage opportunities in fixed income arbitrage as well as short rates react to policy and long rates to inflation expectations and sovereign credit risk. The reduction of capital in fixed income arbitrage also presents interesting arbitrage opportunities between cash, synthetic, futures, forwards, swap and repo markets.

Asset based investing / lending / Trade Finance: The global credit crisis and associated global economic recession has resulted in a dearth of credit. Providers of credit are therefore well rewarded. In trade finance, for example, a sharp fall in world trade of over a third in the final quarter of 2008 was only surpassed by the contraction of available trade finance. Banking consolidations also constrain credit further as obligor limits are exceeded in merged financial institutions. The result is wider spreads and tighter collateral terms. Hedge funds involved in lending are able to use non-traditional deal structures to secure their collateral while exacting competitive spreads.

Credit: A situation in credit markets exists akin to the one in equities. Systemic risk was high in 2008 and credit was systematically sold despite differentiated idiosyncratic issuer risk. The credit space is richer than equities, however, due to the richness of the capital structure, particularly in more mature developed markets like the US, representing excellent raw material for which to express capital structure dislocation trades. Differing natural investors or traders at different parts of the capital structure create arbitrage opportunities which barring unilateral regulatory or government intervention, represent true arbitrage.

Convertible arbitrage: Convertible arbitrage was one of the worst performing strategies in 2008 and one of the best performing strategies in 2009 to June. The losses came from a confluence of general risk aversion, deleveraging by banks and institutions, hedge fund redemptions and failures from over-levered portfolios, and a collapse in the funding mechanism of which the prime brokers were integral. With a normalization of market conditions convertible bond markets have recovered sharply. The crucial question is, to what extent is the current recovery in convert arbitrage funds purely a directional one, profiting from the rising tide lifting all boats. Convertible arbitrage, however, is a catch all for a suite of sub strategies of varying sophistication, direction and use. The current market is replete with less-directional opportunities. These arise from the diversity of pricing and valuation across the convertible space, as well as a revival in primary issuance. The credit elements of convertible arbitrage were highlighted in 2008 and will continue to be a key consideration in assessing convertible bonds. Directional expressions of fundamental views on companies can be very efficiently captured using convertibles as well. A fundamental view on a company need not be restricted to first order (levels) pricing but can extend to views about the pricing of the volatility of the company. Capital structure trades can also be expressed with convertibles for example in theoretical replications with bounded jump to default values for a range of recoveries.

Distressed Credit: When the credit crisis first broke in mid 2007 in the US sub prime real estate mortgage market, investors had already begun to seek opportunities in distressed debt. The distress has been concentrated mostly to the real estate backed securities market and latterly to consumer loan backed securities. Among corporate rated issuers default rates remained low. High yield default rates while accelerating sharply in 2008 had only reached 5.42% by 1Q 2009 according to S&P. S&P expects the default rate to climb to a peak of 14.3% in 2010. Distressed debt managers returns tend lag default rates and accelerate when default rates have peaked. A three to four year period of outperformance is usually measured from the peak of the distressed cycle. This is consistent with the bankruptcy processes of the developed markets such as Chapter 11 in the US. The risk remains that the economic recovery will be an insipid one and or that the economy may sink back into recession before it finds a stable trend path. Distressed debt managers also tend to be weakly correlated at the peak of the default cycle and maintain low correlation for about 3 years after which correlation creeps into their returns.

The events of 2008 have resulted in a peculiar situation where almost every hedge fund strategy is likely to perform well going forward. This is not to say that there is little or no risk. The choice before the investor remains the magnitude and the type of risk they are happy to assume. In liquid strategies such as equity long short, the risk is non-convergence, for there is often no functional relationship to bring relative value trades in line. For strong convergence, such as capital structure arbitrage strategies, convergence is less uncertain, at maturity or in default. However, under going concern assumptions, spreads can be volatile and can widen significantly and sometimes unpredictably. There is a trade off between market risk and liquidity risk.

At various times, the opportunity has shifted from asset class to asset class, from strategy to strategy, requiring a careful portfolio construction to capture the appropriate risk reward characteristics of each strategy, while achieving efficient portfolio diversification. Under current conditions, when risk reward properties of almost every strategy are favourable, the portfolio construction problem is significantly simplified.

Investor Risk Appetite:

In the first half of 2008 investors were content to be worried about their hedge fund allocations while remaining invested. Recall that for the year up till June 2008, hedge funds had turned in a moderately poor (-2.43%) performance. It was only when the losses accumulated and large regulated insurance companies and banks either went bankrupt or threatened to do so, did hedge fund investors decide to redeem in any size. The Madoff fraud further destroyed the trust between investors and their fund managers leading to the demonizing of the entire hedge fund industry not only within the industry but in the general medial as well. Redemptions crescendoed in March 2009 while hedge fund managers, some with liquidity mismatches or funding issues, began to restrict or suspend redemptions in an attempt to avoid disposing of assets at firesale prices.

Hedge fund investors’ reaction, quite understandable began with complacency in early 2008, to fear and panic in 3Q 2008 to despondency in 4Q 2008 and 1Q 2009. The rebound in markets and hedge fund performance took most investors by surprise.

As recently as April / May 2009, investors’ risk aversion remained acutely high. From early June 2009 this has changed somewhat as investors have begun to scout for opportunities in the hedge fund space. A number of things have changed since 2008. For one, investors will no longer tolerate liquidity mismatches, and while the immediate reaction has been to demand liquidity and favour liquid funds, a more discerning investor base is now analysing portfolio and strategy liquidity and requiring fund terms to better reflect the underlying liquidity.

The area of hedge fund fees has also come under scrutiny. While a number of funds have discounted their fees, it is unclear if there is any price elasticity. Price elasticity appears to be a weak factor compared with other factors such as manager quality, rational liquidity terms, transparency and operational integrity. In the area of fees, more sophisticated fees seem to be emerging which seek to better align investor and fund manager interests over a rolling investment horizon instead of the current annual fee crystallization which creates cyclicality in manager behaviour.

Transparency has become the most important issue for investors. Without transparency, due diligence and ongoing monitoring is blunted, style drift and frauds go undetected. Transparency goes beyond, and sometimes around, position level disclosure. More constructive forms of transparency include risk aggregation reports, sometimes sent by the fund administrator, periodic calls with the portfolio manager, periodic portfolio detail. The periodic preference for managed accounts has once again re-emerged. Quite whether it is sustained remains to be seen, but managed accounts while useful in some respects is no panacea.

As hedge funds react to investor needs, a stronger industry will arise, albeit initially a smaller one. It is hard to see growth rates regain their heights in 2007. However, given the relative outperformance of hedge funds versus long only equity, credit fixed income, commodities and real estate both in 2008 and over a 10 year period it is easy to underestimate the growth of the industry.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund articles include:

Hedge Fund PPIP Managers Selected

Treasury and Fed Name Lucky Hedge Fund Managers

The Treasury and the Fed just announced the hedge fund management companies which will be participating in the first round of the PPIP.  The following press release can be found here.

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July 8, 2009
TG-200

Joint Statement by Secretary of the Treasury Timothy F. Geithner,
Chairman of the Board of Governors of the Federal Reserve System
Ben S. Bernanke, and Chairman of the Federal Deposit Insurance Corporation
Sheila Bair on the Legacy Asset Program

To view the Letter of Intent and Term Sheets, please visit link.
To view the Conflict of Interest Rules, please visit link.
To view the Legacy Securities FAQs, please visit link.

The Financial Stability Plan, announced in February, outlined a framework to bring capital into the financial system and address the problem of legacy real estate-related assets.

On March 23, 2009, the Treasury Department, the Federal Reserve, and the FDIC announced the detailed designs for the Legacy Loan and Legacy Securities Programs. Since that announcement, we have been working jointly to put in place the operational structure for these programs, including setting guidelines to ensure that the taxpayer is adequately protected, addressing compensation matters, setting program participation limits, and establishing stringent conflict of interest rules and procedures. Recently released rules are detailed separately in the Summary of Conflicts of Interest Rules and Ethical Guidelines.

Today, the Treasury Department, the Federal Reserve, and the FDIC are pleased to describe the continued progress on implementing these programs including Treasury’s launch of the Legacy Securities Public-Private Investment Program.

Financial market conditions have improved since the early part of this year, and many financial institutions have raised substantial amounts of capital as a buffer against weaker than expected economic conditions.  While utilization of legacy asset programs will depend on how actual economic and financial market conditions evolve, the programs are capable of being quickly expanded if these conditions deteriorate.  Thus, while the programs will initially be modest in size, we are prepared to expand the amount of resources committed to these programs.

Legacy Securities Program

The Legacy Securities program is designed to support market functioning and facilitate price discovery in the asset-backed securities markets, allowing banks and other financial institutions to re-deploy capital and extend new credit to households and businesses. Improved market function and increased price discovery should serve to reinforce the progress made by U.S. financial institutions in raising private capital in the wake of the Supervisory Capital Assessment Program (SCAP) completed in May 2009.

The Legacy Securities Program consists of two related parts, each of which is designed to draw private capital into these markets.

Legacy Securities Public-Private Investment Program (“PPIP”)

Under this program, Treasury will invest up to $30 billion of equity and debt in PPIFs established with private sector fund managers and private investors for the purpose of purchasing legacy securities.  Thus, Legacy Securities PPIP allows the Treasury to partner with leading investment management firms in a way that increases the flow of private capital into these markets while maintaining equity “upside” for US taxpayers.

Initially, the Legacy Securities PPIP will participate in the market for commercial mortgage-backed securities and non-agency residential mortgage-backed securities.  To qualify, for purchase by a Legacy Securities PPIP, these securities must have been issued prior to 2009 and have originally been rated AAA — or an equivalent rating by two or more nationally recognized statistical rating organizations — without ratings enhancement and must be secured directly by the actual mortgage loans, leases, or other assets (“Eligible Assets”).

Following a comprehensive two-month application evaluation and selection process, during which over 100 unique applications to participate in Legacy Securities PPIP were received,  Treasury has pre-qualified the following firms (in alphabetical order) to participate as fund managers in the initial round of the program:

  • AllianceBernstein, LP and its sub-advisors Greenfield Partners, LLC and Rialto Capital Management, LLC;
  • Angelo, Gordon & Co., L.P. and GE Capital Real Estate;
  • BlackRock, Inc.;
  • Invesco Ltd.;
  • Marathon Asset Management, L.P.;
  • Oaktree Capital Management, L.P.;
  • RLJ Western Asset Management, LP.;
  • The TCW Group, Inc.; and
  • Wellington Management Company, LLP.

Treasury evaluated these applications according to established criteria, including: (i) demonstrated capacity to raise at least $500 million of private capital; (ii) demonstrated experience investing in Eligible Assets, including through performance track records; (iii) a minimum of $10 billion (market value) of Eligible Assets under management; (iv) demonstrated operational capacity to manage the Legacy Securities PPIP funds in a manner consistent with Treasury’s stated Investment Objective while also protecting taxpayers; and (iv) headquartered in the United States.  To ensure robust participation by both small and large firms, these criteria were evaluated on a holistic basis and failure to meet any one criterion did not necessarily disqualify an application.

Each Legacy Securities PPIP fund manager will receive an equal allocation of capital from Treasury.  These Legacy Securities PPIP fund managers have also established meaningful partnership roles for small-, veteran-, minority-, and women-owned businesses. These roles include, among others, asset management, capital raising, broker-dealer, investment sourcing, research, advisory, cash management and fund administration services.  Collectively, the nine pre-qualified PPIP fund managers have established 10 unique relationships with leading small-, veteran-, minority-, and women-owned financial services businesses, located in five different states, pursuant to the Legacy Securities PPIP.  Moreover, as Treasury previously announced, small-, veteran-, minority-, and women-owned businesses will continue to have the opportunity to partner with selected fund managers following pre-qualification.  Set forth below is a list (in alphabetical order) of the established small-, veteran-, minority-, and women-owned businesses partnerships:

  • Advent Capital Management, LLC;
  • Altura Capital Group LLC;
  • Arctic Slope Regional Corporation;
  • Atlanta Life Financial Group, through its subsidiary Jackson Securities LLC;
  • Blaylock Robert Van, L.L.C.;
  • CastleOak Securities, LP;
  • Muriel Siebert & Co., Inc.;
  • Park Madison Partners LLC;
  • The Williams Capital Group, L.P.; and
  • Utendahl Capital Management.

In addition to the evaluation of applications, Treasury has conducted legal, compliance and business due diligence on each pre-qualified Legacy Securities PPIP fund manager.  The due diligence process encompassed, among other things, in-person management presentations and limited partner reference calls.  Treasury has negotiated equity and debt term sheets (see attached link for the terms of Treasury’s equity and debt investments in the Legacy Securities PPIP funds) for each pre-qualified Legacy Securities PPIP fund manager.  Treasury will continue to negotiate final documentation with each pre-qualified fund manager with the expectation of announcing a first closing of a PPIF in early August.

Each pre-qualified Legacy Securities PPIP fund manager will have up to 12 weeks to raise at least $500 million of capital from private investors for the PPIF.  The equity capital raised from private investors will be matched by Treasury.  Each pre-qualified Legacy Securities PPIP fund manager will also invest a minimum of $20 million of firm capital into the PPIF.  Upon raising this private capital, pre-qualified Legacy Securities PPIP fund managers can begin purchasing Eligible Assets.  Treasury will also provide debt financing up to 100% of the total equity of the PPIF.  In addition, PPIFs will be able to obtain debt financing raised from private sources, and leverage through the Federal Reserve’s and Treasury’s Term Asset-Backed Securities Loan Facility (TALF), for those assets eligible for that program, subject to total leverage limits and covenants.

Legacy Securities and the Term Asset-Backed Securities Loan Facility

On May 19, 2009, the Federal Reserve Board announced that, starting in July 2009, certain high-quality commercial mortgage-backed securities issued before January 1, 2009 (“legacy CMBS”) would become eligible collateral under the TALF. The Federal Reserve and the Treasury also continue to assess whether to expand TALF to include legacy residential mortgage-backed securities as an eligible asset class.

The CMBS market, which has financed approximately 20 percent of outstanding commercial mortgages, including mortgages on offices and multi-family residential, retail and industrial properties, came to a standstill in mid-2008. The extension of eligible TALF collateral to include legacy CMBS is intended to promote price discovery and liquidity for legacy CMBS. The announcements about the acceptance of CMBS as TALF collateral are already having a notable impact on markets for eligible securities.

Legacy Loan Program

In order to help cleanse bank balance sheets of troubled legacy loans and reduce the overhang of uncertainty associated with these assets, the FDIC and Treasury designed the Legacy Loan Program alongside the Legacy Securities PPIP.

The Legacy Loan Program is intended to boost private demand for distressed assets and facilitate market-priced sales of troubled assets. The FDIC would provide oversight for the formation, funding, and operation of a number of vehicles that will purchase these assets from banks or directly from the FDIC. Private investors would invest equity capital and the FDIC will provide a guarantee for debt financing issued by these vehicles to fund asset purchases. The FDIC’s guarantee would be collateralized by the purchased assets.  The FDIC would receive a fee in return for its guarantee.

On March 26, 2009, the FDIC announced a comment period for the Legacy Loan Program, and has now incorporated this feedback into the design of the program. The FDIC has announced that it will test the funding mechanism contemplated by the LLP in a sale of receivership assets this summer. This funding mechanism draws upon concepts successfully employed by the Resolution Trust Corporation in the 1990s, which routinely assisted in the financing of asset sales through responsible use of leverage. The FDIC expects to solicit bids for this sale of receivership assets in July. The FDIC remains committed to building a successful Legacy Loan Program for open banks and will be prepared to offer it in the future as needed to cleanse bank balance sheets and bolster their ability to support the credit needs of the economy. In addition, the FDIC will continue to work on ways to increase the utilization of this program by open banks and investors.

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For related hedge fund law and industry articles, please see:

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.

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Series 79 Exam

FINRA to Announce New Investment Banking Examination

For many years now all brokers have been treated equally with regard to examination requirements. Whether a broker was working solely with retail clients or solely with institutions on a private placement basis, each such broker would need to take and pass the Series 7 examination in order to become a representative (broker) at the BD (broker firm or broker-dealer). Now, however, there will be a new exam for those brokers whose only acitivites are “investment banking” activities. In the near future these brokers will only need to take and pass a new exam called the Series 79 exam which will presumably be more focused and shorter than the all-day Series 7 exam. I will continue to update this article after the 4th of July weekend, but below I have included the full text of the new FINRA Rule 1032(i) which provides for a new Investment Banking representative registration.

Text of Rule 1032(i)

FINRA Rule 1032. Categories of Representative Registration

(a) through (h) No change.

(i) Limited Representative-Investment Banking

(1) Each person associated with a member who is included within the definition of a representative as defined in NASD Rule 1031 shall be required to register with FINRA as a Limited Representative-Investment Banking and pass a qualification examination as specified by the Board of Governors if such person’s activities involve:

(A) advising on or facilitating debt or equity securities offerings through a private placement or a public offering, including but not limited to origination, underwriting, marketing, structuring, syndication, and pricing of such securities and managing the allocation and stabilization activities of such offerings, or

(B) advising on or facilitating mergers and acquisitions, tender offers, financial restructurings, asset sales, divestitures or other corporate reorganizations or business combination transactions, including but not limited to rendering a fairness, solvency or similar opinion.

(2) Notwithstanding the foregoing, an associated person shall not be required to register as a Limited Representative-Investment Banking if such person’s activities described in paragraph (i)(1) are limited to:

(A) advising on or facilitating the placement of direct participation program securities as defined in NASD Rule 1022(e)(2);

(B) effecting private securities offerings as defined in paragraph (h)(1)(A); or

(C) retail or institutional sales and trading activities.

(3) An associated person who participates in a new employee training program conducted by a member shall not be required to register as a Limited Representative-Investment Banking for a period of up to six months from the time the associated person first engages within the program in activities described in paragraphs (i)(1)(A) or (B), but in no event more than two years after commencing participation in the training program. This exception is conditioned upon the member maintaining records that:

(A) evidence the existence and details of the training program, including but not limited to its scope, length, eligible participants and administrator; and

(B) identify those participants whose activities otherwise would require registration as a Limited Representative-Investment Banking and the date on which each participant commenced such activities.

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Please contact us if you have any questions or would like to  learn how to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Hedge Funds with $25MM of AUM to Register Under Commissioner Aguilar’s Plan

SEC Commissioner Aguilar Proposes Registration For Funds with as little as $25MM of AUM

Just today I had an opportunity to review the transcript of a speech by SEC Commissioner Aguilar in which he advocates that funds with as little as $25MM of AUM should register with the SEC.  Such a low threshold for registration is troubling in a number of ways.  Most importantly is the impact registration would have on the SEC immediately and in the future.  As we have seen most vividly over the past year, the SEC is overextended and underfunded.  The SEC’s ability to adequately deal with the 9,000 to 12,000 hedge funds which would come under its jurisdicition is suspect.  Registration aside, how will an agency which was not able to sniff out a Bernie Madoff be able to oversee such a large industry without making it cost prohibitive for funds to operate?  The money required to oversee these funds is likely to be substantial and will probably not be coming from Congress which means the cost of such a regulatory and oversight system will likely fall onto the managers themselves and then of course to the investors.

As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.

To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.

This is not to say I am not against reasonable, reasoned and fiscally responsible oversight and regulation.  I believe that systemic stability is critically important for the long term viability of the hedge fund industry as well as the capital markets.  In this vein, I think that Aguilar’s statement below represents the type of structures which would contribute to increased stability while minimizing regulation where it is not necessary.

Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.

While I do not agree with many of the points regarding regulation the Commissioner discussed in the speech reprinted below, I do believe that the Commissioner does a good job at identifying issues which should be discussed publicly as regulators and industry participants move towards creating a reasonable regulatory regime.

Please feel free to include your comments below.

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Speech by SEC Commissioner:
Hedge Fund Regulation on the Horizon — Don’t Shoot the Messenger
by

Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission
Spring 2009 Hedgeworld Fund Services Conference
New York, New York

June 18, 2009

Thank you for that kind introduction. I am pleased to be here with you at the Spring 2009 Hedgeworld Fund Services Conference. This conference is timely given the current discussion regarding potential regulation of the hedge fund industry. Let me say at the outset, as is customary, my remarks today are my own and do not necessarily reflect the views of my fellow Commissioners or of the Commission staff.

My experience with the securities industry began in the late 1970’s. After three years with the SEC, I’ve spent the bulk of my 30 years as a lawyer focusing on the capital markets. Most of those years where in private practices in large law firms, although I spent most of the 90’s and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager. While I’ve spent much of my professional career involved in capital formation though public and private offerings, a substantial portion has been spent working in the investment management industry, and I have worked with hedge funds.

As we all know, there has been much speculation about the impact of hedge fund activity on the broader capital markets. For example, there are questions about whether hedge funds may have contributed to the market turmoil and how hedge funds may have contributed to the demise of Bear Stearns, Lehman Brothers and others. Additionally, it is also not clear whether the lack of oversight of the industry resulted in large amounts of risk to the market through the use of short sales and derivatives, such as credit default swaps.

This year’s conference takes place at a key moment in the history of hedge funds. While hedge funds have remained largely unregulated, this seems to be coming to an end. All over the world, legislators, regulators, investor groups, industry representatives and others are loudly calling for the industry to be regulated.

In the United States, the calls for regulation are motivated by concerns that market integrity has been harmed and that systemic risk arose as a result of the exemptions and exclusions from the federal securities laws that permitted a private market to thrive in ways that may have harmed the public markets. In fact, the market turmoil clearly demonstrated that the private fund market does impact the broader capital markets. This does not mean that all fund activity must be equally regulated, but hedge funds, especially large ones, are thought to require greater regulatory oversight.

My goal with my remarks today is to:

  • First, lay out a current state of affairs regarding the hedge fund industry;
  • Second, describe the calls for regulation of the industry; and
  • Third, discuss key considerations that need to be assessed as hedge fund regulation moves forward.

Multiple Voices Calling For Regulation

The hedge fund industry looks very different today than from where it started. Since the first hedge fund was organized by Alfred Jones in 1949 with $100,000, the industry has exponentially grown both in number of funds and in number of assets under management. In recent years, this growth has been fueled in part by institutional investors, such as endowments, foundations, insurance companies, and pension plans. To give you an idea of the growth, it is believed that the industry managed around $38 billion in 1990, $625 billion in 2002, and reached $1.9 trillion at the end of 2007, although that the number decreased to $1.3 trillion at the end of 2008. It is still incredible growth from the $100,000 start.

The industry’s growth, and the concerns over the impact of hedge funds on the marketplace, has created a renewed call for regulation in the U.S. and abroad. For example, the European Commission recently proposed to regulate the managers of hedge funds and all private equity funds with 100 million euros in assets under management. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.

In the U. S., a few years ago the SEC unsuccessfully attempted to regulate hedge funds. More recently, in March of this year, Treasury Secretary Timothy Geithner testified about his plan to more tightly oversee hedge funds. In addition, there recently have been at least a half-dozen bills introduced in Congress requiring regulation of the hedge fund industry. Just this past Tuesday, Senator Jack Reed introduced a bill that would require that advisers to hedge funds, and to certain other investment pools, to register with the SEC. And yesterday, of course, the Obama Administration released a draft white paper that, among other things, proposes that advisers to large hedge funds register with the SEC, and that very large advisers be subject to additional federal supervision by the Federal Reserve Board.

What are the concerns underlying the call for government oversight? I will tell you what we are hearing. The concerns touch on the classic financial regulatory interests: such as market integrity concerns, systemic risk concerns, and investor protection concerns. This state of affairs is what you would expect when markets are inextricably integrated and the impact of hedge funds is significant, but their actions and their risks are opaque. Simply stated, regulators, legislators and the public have little credible information as to who is out there and what they are doing.

Market Integrity Concerns

Let’s start with the SEC’s responsibility to maintain fair and orderly markets. One of the concerns about hedge funds involves how hedge fund operations impact upon the fairness and the integrity of the broader market. The lack of transparency and oversight over hedge funds gives rise to a number of concerns — for example, market integrity concerns about the nature and extent of counterparty risk, concerns about whether hedge funds engage in insider trading, and questions about how hedge funds drive the demand for derivatives, such as CDSs, as well as how they impact the demand for securitized products.

As a predicate for discussion, let’s be clear about the significant market activity of hedge funds. For example, hedge funds reportedly account for more than 85% of the distressed debt market, and more than 80% of certain derivatives markets. Moreover, although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume. In 2006, there were estimates that hedge funds were responsible for as much as half of the daily trading volume on the New York Stock Exchange.

Because hedge funds are not subject to leverage or diversification requirements, hedge fund managers can more easily take concentrated positions that can impact the market. For example, an entire fund or even multiple funds advised by the same hedge fund manager can be invested in a single position.

In addition, hedge funds are major players in the capital markets for reasons other than trading activity. As this audience knows well, hedge funds have significant business relationships with the largest regulated commercial and investment banks — and act as trading counterparties for a wide range of OTC derivatives and other financing transactions.

Counterparty Risk Concerns

Clearly, for all these reasons and others, hedge funds are significant players in the capital markets. As significant players, hedge funds are one source of counterparty risk, and this risk can be amplified by their leverage and opacity.

Today, commercial banks and prime brokers are called upon to bear and manage the credit and counterparty risks that hedge fund leverage creates. Up until now, it has been assumed that market discipline would effectively prevent hedge funds from detrimentally impacting the capital markets or from posing systemic risk. A January 2008 GAO Report, however, identified several concerns with that theory.[1] For example, the report noted that hedge funds use multiple prime brokers and questioned whether any single prime broker has a complete picture of a hedge fund client’s total leverage. Accordingly, the stress tests and other tools that a prime broker uses to monitor a given counterparty’s risk profile only incorporate the positions known to that particular prime broker. Thus, no single prime broker has the whole picture.

The GAO Report also stated that some counterparties may lack the capacity to assess risk exposures because of the complex financial instruments and secret investment strategies that some hedge funds use.

Unfortunately, the GAO Report also indicates that counterparties facing these structural limitations may have also actively relaxed credit standards in order to attract and retain hedge fund clients in response to fierce competition.

In each of these instances, the risks of hedge funds are being externalized to the regulated market — prime brokers, banks, and their shareholders each were asked to bear the costs of managing hedge fund risks. A concrete example you may remember was when two Bear Stearns-sponsored hedge funds collapsed in 2007. Merrill Lynch, one of the prime brokers, had to absorb an enormous loss because it could only sell the funds’ collateral for a fraction of its purported value.

It’s been obvious that the regulatory oversight of hedge funds has not matched their level of market activity. This difference has led to other concerns affecting market integrity.

Risks of Insider Trading Create Market Wide Concerns

For example, in addition to concerns about counterparty risk, there have also been concerns about hedge funds engaging in insider trading. Clearly, there has been an increase in the number of insider trading cases brought by the Commission that have involved hedge funds. Admittedly, it is incredibly difficult for the Commission to assess the frequency of insider trading because of the opacity of hedge funds and the investments they make, especially in OTC derivatives. Moreover, when you couple this with the fragmented nature of the securities markets and the broad potential for hedge funds to obtain inside information, it is a tough oversight situation indeed. Hedge funds who participate in private placements, talk with trading desks, and maintain connections with the street are, in many cases, in a position to obtain inside information and to use it in a way that traditional surveillance may not detect. This potential for insider trading has been well publicized and public investors are concerned about the possible effects on market fairness and integrity.

Hedge Funds And The Demand For CDS and Securitized Products

Additionally, hedge funds were significant players in the exponential growth in the now much maligned credit default swaps market. As the market to create CDSs grew, there were funds that bought these instruments for reasons that made sense. For example, in 2005 there were hedge funds who noticed that the U.S. housing market was weakening and they bought CDS instruments on the protection buyer side. A logical move.

On the other hand, it is well known that the credit risk reflected by CDSs is equal to multiples of the actual credit risk of the underlying bond market. How did that happen? Many CDSs were heralded as hedging tools — they were supposed to transfer risk to parties that could bear it from parties that could not. Now we see only too clearly that this was not the case. Instead, many CDSs actually created risk, rather than hedged risk. Hedge funds that sought to create profits from leveraged risk may have played a crucial role driving the growth in these products.

Systemic Risks

The concerns about hedge funds and market integrity often go hand in hand with concerns about systemic risk. In their current form, hedge funds pose a systemic risk threat to our financial system in several ways. First, hedge funds have such significant assets under management that some fear that the loss of one or more large firms could potentially reverberate throughout the capital markets. In addition, if a counterparty fails to effectively withstand a hedge fund loss, then the failure of the counterparty could itself threaten market stability.

There is also the issue that can occur when several hedge funds take the same position, whether through coordination or simply through similar trading strategies. These funds can have a large impact on the market when they adjust their positions en masse.

Thus, the concerns that the lack of oversight over the hedge fund industry may present to market integrity and to systemic risks seem to be well founded.

Investor Protection

In addition to concerns about market integrity, the SEC is also responsible for investor protection. Given the increase in complaints from hedge fund investors this has taken on a more immediate importance.

One of the underlying principles behind the idea that hedge funds could operate with little to no regulatory requirements was that interests in the funds were only sold in private offerings to wealthy investors. These investors were thought to be sufficiently “sophisticated” to protect their interests, and to be able to engage in effective arms-length negotiation in order to achieve fair and equitable terms.

I firmly believe that truly sophisticated investors in private deals should be held accountable to the terms that they knowingly negotiate — and if an investment were to go bad, they should bear the loss.

However, with the recent market turmoil and the ongoing economic upheaval that has caused trillions in wealth to vanish, millions of jobs to disappear and the liquidation of over 1,500 hedge funds, serious concerns have been raised about whether these wealthy and sophisticated investors are truly able to protect their interests. There seems to be evidence that these “sophisticated investors” may not have fully appreciated the risks they were taking. Perhaps it may make sense for the definitions of who qualifies as “sophisticated” under our rules to be reconsidered. For example, maybe the criteria for sophistication should focus on more relevant attributes — such as focusing on actual investment experience.

In any case, recent events have challenged the assumption that investors and market discipline can be relied upon to control the risks of hedge funds. And this is not surprising. First, these investors are typically passive and there is no legal obligation for hedge fund investors to monitor hedge fund activity. Second, even if investors wanted to actively monitor the investment, the nature of hedge fund activity and the information available may not currently support such a role.

Valuation and Performance

For example, it may be impossible for an investor to know the actual value of a hedge fund’s portfolio. Hedge funds are not subject to reporting requirements and because many instruments held by a hedge fund are illiquid or opaquely-priced OTC products, any information that is reported could be hard to evaluate.

Related to the concern of how a fund values its assets, is a hedge fund’s performance information — another hard to evaluate metric for investors. Without regulation, the only performance information that hedge funds provide is voluntary.

This quote by Harry Liem, a pension consultant, seems to sum it up when he said “It’s like someone walking into a casino and saying ‘I want everyone to come forward and tell me how much you have won or lost.’ Probably only the winners will come forward . . .”[2]

Not Being Able to Redeem

There is also the issue of investors not being able to redeem their investments from a fund. In recent times, due to the large amount of redemption requests and the current lack of an ability to raise cash, there are hedge fund managers who have put up gates and have restricted investors’ ability to redeem their monies. Although gates can benefit investors by giving the manager more time to sell off portfolio positions, for some investors it appeared to be a surprise.

On top of that, several hedge fund managers froze funds but continued to charge management fees on money that investors cannot access. Orin Kramer, a hedge fund manager, described the situation by stating: “It’s like telling someone at a hotel that they can’t check out and then charging them for the privilege of staying.”[3]

Let me be clear. I’m not saying that these situations are per se illegal. To the extent that sophisticated and qualified investors agreed to provisions providing for gates and the ongoing charge of management fees, one could say that investors walked into these agreements with open eyes.

However, because for the most part hedge funds are not registered with the SEC, we are not able to adequately oversee how they are operating. Moreover, this lack of transparency makes it difficult to assess whether the relationship between an investor and the hedge funds adviser, is functioning in the manner that underlie the presumptions that led to the exemptions.

Some recent reports do tend to show that investors are beginning to take their own initiatives, and give some indication that what investors may be willing to agree to in the future may be different. For example, a recent memo from CalPERS stated that it would no longer partner with managers whose fee structures result in a clear misalignment of interest between managers and investors. Moreover, more investors are now asking that hedge funds run assets in “managed accounts,” where their money is held separately and the holdings are transparent.

As you may expect based on concerns including ones I have mentioned, hedge fund investors have been calling the Commission in unprecedented numbers

Increased Cases Involving Hedge Funds

In fact, the Commission has more investigations involving hedge funds than ever before, and the number of cases actually brought also is increasing. In the first 4 months of 2009, the Commission filed 25 cases related to hedge funds. In contrast, we brought 19 cases in all of 2008, 24 in all of 2007, and 16 in 2006. Our cases cover the waterfront, charging everything from offering fraud and insider trading, to misrepresentations about performance and to misrepresentations about the actual due diligence undertaken. We are also seeing more cases involving conflicts of interest and outright theft of assets

Nature of Regulation

I have just laid out for you some of the concerns that are generally driving the calls for greater regulation and oversight of the hedge fund industry. Maybe even more important, it appears that some of the assumptions justifying the industry’s exclusion from regulation and oversight may be on faulty ground. As a result, it seems certain that regulation of the hedge fund industry is coming. But here is the harder question — what should it look like?

There are a number of questions as to exactly how, and to what extent, hedge funds may have contributed to the economic crisis and how they contributed to the overall systemic risk of the financial markets. To that end, I applaud Congress and President Obama for providing for an independent, bi-partisan Financial Crisis Inquiry Commission. By investigating and analyzing what happened, we can better assess whether the regulatory proposals should move forward.

Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate hedge funds.

Because of the size, complexity and market-wide impact of the hedge funds industry, potential regulation would need to be both comprehensive and flexible. Something not always easy to achieve.

I believe that the SEC must be an active participant in this process. Please remember that the SEC has been overseeing industry participants — such as, investment companies, investment advisers and broker-dealers — for over 69 years. The Commission staff has unsurpassed expertise in this area. Congress should take advantage of this expertise by providing the Commission with a broad mandate to oversee hedge funds. The Commission could then scale its regulation in a flexible manner to deal with the regulatory concerns of market integrity, investor protection, and, in coordination with other regulators, systemic risk.

Working with hedge fund advisers and with hedge fund investors, I am confident that we can find an appropriate balance.

As you know, there has been a general discussion over whether hedge fund advisers and/or hedge funds should register. In my mind, hedge funds advisers with over $25 million in assets should register with the Commission, but that may not be enough. Many hedge fund advisers are currently registered with the SEC but we still lack a complete picture of what is going on in the industry. Some have suggested that hedge funds should also register. Others have suggested that it may be appropriate to apply limited concepts from within the Investment Company Act of 1940 to hedge funds — what some have called a “40 Act-lite” regime.

Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.

For funds that could significantly affect the market, it may be appropriate to require more than recordkeeping. For example, it may be appropriate to think through whether some of the risk limitation concepts built into the Investment Company Act make sense to apply to these hedge funds — such as imposing limits on leverage.

Of course, these are only a few suggestions. Many others have been made — and others will follow — as the discussion turns from “whether to regulate” to “how to regulate.” The nature of the business of hedge funds is trading, and this necessarily requires interaction with the public marketplace — and the larger the investment fund, the greater the potential impact on the overall capital markets. When the hedge industry has the ability to significantly impact the market or other market participants, the public interest needs to be protected. A lesson of this economic crisis is that the U.S. regulatory interest in hedge funds arises because of the impact of the funds on the financial market, regardless of the sophistication of its investors or the number of investors.

When discussing “how to regulate,” it is clear to me that regulation is more than the bare requirements of registering and reporting — it should also include inspection authority. To have a chance to prevent problems before they occur, the SEC has to be able to inspect all hedge fund advisers, and the funds that they manage, and otherwise engage in oversight through surveillance systems. The public expects nothing less.

Greater Resources to SEC to Provide Effective Oversight

As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.

To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.

Conclusion

In conclusion, I am confident that regulation of the hedge fund industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. And if it is, it will be a good thing for all of us. The Congressional Oversight Panel’s Special Report on Regulatory Reform4 said it best with the following summary:

“By limiting the opportunities for deception and allowing for the necessary trust to develop between interconnected parties, regulation can enhance the vitality of the markets. Historically, new regulation has served that role.
For example, as the money manager Martin Whitman has observed, far from stifling the markets, the new regulations of the Investment Company Act enabled the targeted industry to flourish:

“’Without strict regulation, I doubt that our industry could have grown as it has grown, and also be as prosperous as it is for money managers. Because of the existence of strict regulation, the outside investor knows that money managers can be trusted. Without that trust, the industry likely would not have grown the way it had grown.’”[5]

The lack of transparency, potential imbalance of power between investors and managers, and impact on the entire capital market are driving the calls to regulate the hedge fund industry. The hedge fund industry has a lot to offer in determining how these calls are answered. Addressing these issues in an intelligent and rational manner is important, and ultimately will result in a stronger and more vibrant hedge fund industry. I welcome the ongoing discussion.

Thank you for inviting me here today.

Endnotes

[1] GAO Report: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention is Needed. January 2008. pg 27.

[2] Why people love to hate those risky hedge funds; An investment option that only the super rich can afford, by Naomi Rovnick. South China Morning Post Ltd. March 1, 2009.

[3] Hedge Funds, Unhinged by Louise Story. New York Times. January 18, 2009.

[4] Congressional Oversight Panel’s Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability. January 2009. pgs 18-19

[5] Letter from Third Avenue Funds Chairman of the Board Martin J. Whitman to Sharheolders, at 6 (Oct. 31, 2005) (online at www.thirdavenuefunds.com/ta/documents/sl/shareholderletters-05Q4.pdf).

http://www.sec.gov/news/speech/2009/spch061809laa.htm

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Please contact us if you have any questions or would like to  learn how to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Consumer Financial Protection Agency Act of 2009

As part of the new Obama financial regulation plan, which includes potentially the registration of hedge fund managers with the SEC, the Whitehouse has sent a draft to congress of the new Consumer Financial Protection Agency Act of 2009 (CFPAA of 2009).  The act would create a new government agency which would have some interaction with both the SEC and the CFTC.  A full version of the draft can be found here: Consumer Financial Protection Agency Act of 2009.  Additionally, you can find President Obama’s statement with regard to this new agency reprinted below.  For more information, please also see Jim Hamilton’s website.

More posts about this new act and what it will mean to hedge funds will be forthcoming.

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THE WHITE HOUSE

Office of the Press Secretary
EMBARGOED UNTIL 6:00 AM ET,

SATURDAY, June 20, 2009

WEEKLY ADDRESS: President Obama Highlights Tough New Consumer Protections

WASHINGTON – In his weekly address, President Barack Obama explained the necessity of his proposed Consumer Financial Protection Agency.  It is clear that one of the major causes of the current economic crisis was a breakdown of oversight leading to widespread abuses in the financial world.  The Consumer Financial Protection Agency will have the sole job of looking out for the financial interests of ordinary Americans by banning unfair practices and enforcing the rules.  This is the type of reform that will attack the causes of the current crisis and prevent further crises from taking place.

The audio and video will be available at 6:00am Saturday, June 20, 2009 at www.whitehouse.gov.

Prepared Remarks of President Barack Obama
Weekly Address
June 20, 2009

As we continue to recover from an historic economic crisis, it is clear to everyone that one of its major causes was a breakdown in oversight that led to widespread abuses in the financial system. An epidemic of irresponsibility took hold from Wall Street to Washington to Main Street.  And the consequences have been disastrous. Millions of Americans have seen their life savings erode; families have been devastated by job losses; businesses large and small have closed their doors.

In response, this week, my administration proposed a set of major reforms to the rules that govern our financial system; to attack the causes of this crisis and to prevent future crises from taking place; to ensure that our markets can work fairly and freely for businesses and consumers alike.

We are going to promote markets that work for those who play by the rules. We’re going to stand up for a system in which fair dealing and honest competition are the only way to win. We’re going to level the playing field for consumers. And we’re going to have the kinds of rules that encourage innovations that make our economy stronger – not those that allow insiders to exploit its weaknesses for their own gain.

And one of the most important proposals is a new oversight agency called the Consumer Financial Protection Agency. It’s charged with just one job: looking out for the interests of ordinary Americans in the financial system. This is essential, for this crisis may have started on Wall Street.  But its impacts have been felt by ordinary Americans who rely on credit cards, home loans, and other financial instruments.

It is true that this crisis was caused in part by Americans who took on too much debt and took out loans they simply could not afford. But there are also millions of Americans who signed contracts they did not always understand offered by lenders who did not always tell the truth. Today, folks signing up for a mortgage, student loan, or credit card face a bewildering array of incomprehensible options. Companies compete not by offering better products, but more complicated ones – with more fine print and hidden terms.  It’s no coincidence that the lack of strong consumer protections led to abuses against consumers; the lack of rules to stop deceptive lending practices led to abuses against borrowers.

This new agency will have the responsibility to change that. It will have the power to set tough new rules so that companies compete by offering innovative products that consumers actually want – and actually understand. Those ridiculous contracts – pages of fine print that no one can figure out – will be a thing of the past. You’ll be able to compare products – with descriptions in plain language – to see what is best for you.  The most unfair practices will be banned. The rules will be enforced.

Some argue that these changes – and the many others we’ve called for – go too far. And I welcome a debate about how we can make sure our regulations work for businesses and consumers. But what I will not accept – what I will vigorously oppose – are those who do not argue in good faith. Those who would defend the status quo at any cost. Those who put their narrow interests ahead of the interests of ordinary Americans. We’ve already begun to see special interests mobilizing against change.

That’s not surprising. That’s Washington.

For these are interests that have benefited from a system which allowed ordinary Americans to be exploited. These interests argue against reform even as millions of people are facing the consequences of this crisis in their own lives. These interests defend business-as-usual even though we know that it was business-as-usual that allowed this crisis to take place.

Well, the American people did not send me to Washington to give in to the special interests; the American people sent me to Washington to stand up for their interests.  And while I’m not spoiling for a fight, I’m ready for one. The most important thing we can do to put this era of irresponsibility in the past is to take responsibility now. That is why my administration will accept no less than real and lasting change to the way business is done – on Wall Street and in Washington. We will do what is necessary to end this crisis – and we will do what it takes to prevent this kind of crisis from ever happening again.

Thank you.

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Please contact us if you have any questions or would like to  learn how to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Law Blog Statistics | June 2009

Most Read Hedge Fund Law Articles for June

I wanted to take a little time to thank all of the people who read this blog and who take the time to comment on articles or send me questions – your interaction helps make this site more informative and a better resource for everyone.  If you have any questions related to any of the articles, I ask you send them to me through the contact form.  If you have an RSS reader, please consider subscribing to the hedge fund law RSS feed to stay up to date on the new content posted in this site.

Hedge Fund Visitors for June 2009

According to Google Analytics, the following is the information on the number and people who have visited the website during the past month:

  • Visits – 14,744  (of these 10,472 were new visitors)
  • Absolute Unique Visitors – 11,415
  • Pageviews – 33,031
  • Top Nations – United States, United Kingdom, India, Canada, Hong Kong, Switzerland, France, Australia, Singapore, Germany

Top 10 Hedge Fund Law Stories for June 2009

According to Google Analytics, the following is a list of the most popular hedge fund articles for the month of June:

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Hedge Fund Regulation Principles

IOSCO Pushes Securities Regulators to Adopt Registration Provisions

Over the past few months we have been highlighting the Congressional attempts to regulate and/or register hedge funds and more recently have discussed the Obama hedge fund registration plan.  However, we have not discussed what is happening internationally.  Like the in the US, other major financial centers around the world have suffered from the economic downturn and have begun looking towards greater regulation of the financial system – this of course means greater regulation of hedge funds and registration for hedge fund managers.

There has been much discussion, both in the US and abroad, about world-wide principles for regulation.  There would be obvious benefits for some sort of international standards for all parts of the financial system, but there would need to be an unprecedented amount of cooperation between the various financial regulatory agencies which seems like an insurmountable task.  However, one group, the International Organization of Securities Commissions’ (IOSCO), is doing its best to act as a sort of communicator of best practices that financial regulatory systems should integrate into new regulations which are expected to be proposed in many jurisdictions.

Below I have published a press release announcing the IOSCO’s report on hedge fund oversight.  The full 26 page report, IOSCO Hedge Fund Regulation Report, tackles some of the high level issues which regulatory bodies should consider when drafting new hedge fund regulations.  It will be interesting to see how this report is received in the different jurisdictions throughout the world.

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IOSCO/MR/12/2009
Madrid, 22 June 2009

IOSCO publishes principles for hedge funds regulation

The International Organization of Securities Commissions’ (IOSCO) Technical Committee has today published Hedge Funds Oversight: Final Report which contains six high level principles that will enable securities regulators to address, in a collective and effective way, the regulatory and systemic risks posed by hedge funds in their own jurisdictions while supporting a globally consistent approach.

The report, which was prepared by the Task Force on Unregulated Entities (Task Force), recommends that all securities regulators apply the principles in their regulatory approaches.

The six high level principles are:

  1. Hedge funds and/or hedge fund managers/advisers should be subject to mandatory registration;
  2. Hedge fund managers/advisers which are required to register should also be subject to appropriate ongoing regulatory requirements relating to:
    1. Organisational and operational standards;
    2. Conflicts of interest and other conduct of business rules;
    3. Disclosure to investors; and
    4. Prudential regulation.
  3. Prime brokers and banks which provide funding to hedge funds should be subject to mandatory registration/regulation and supervision. They should have in place appropriate risk management systems and controls to monitor their counterparty credit risk exposures to hedge funds;
  4. Hedge fund managers/advisers and prime brokers should provide to the relevant regulator information for systemic risk purposes (including the identification, analysis and mitigation of systemic risks);
  5. Regulators should encourage and take account of the development, implementation and convergence of industry good practices, where appropriate;
  6. Regulators should have the authority to co-operate and share information, where appropriate, with each other, in order to facilitate efficient and effective oversight of globally active managers/advisers and/or funds and to help identify systemic risks, market integrity and other risks arising from the activities or exposures of hedge funds with a view to mitigating such risks across borders.

Kathleen Casey, Chairman of the Technical Committee, said:

“Securities regulators recognise that the current crisis in financial markets is not a hedge fund driven event. Hedge funds contribute to market liquidity, price efficiency, risk distribution and global market integration. Nevertheless the crisis has given regulators the opportunity to consider the systemic role hedge funds may play and the way in which we deal with the regulatory risks they may pose to the oversight of markets and protection of investors.

“The application of these principles, in a collective, cooperative and efficient way, can provide regulators with the tools to obtain sufficient, relevant information in order to address the regulatory and systemic risks posed by hedge funds.”

The Task Force was chaired by the CONSOB of Italy and the Financial Services Authority of the United Kingdom. It was established in November 2008 to support the initiatives undertaken by the G-20 to restore global growth and achieve reforms in the world’s financial systems.

The Task Force will continue to work to support the implementation of these standards by its members and to deal with future regulatory issues that may arise in relation to hedge funds. It will act as the contact point with prudential regulators and banking standards setters, as well as other regulatory bodies such as the Joint Forum and the hedge fund industry in relation to the development and implementation of industry standards of best practice.

NOTES FOR EDITORS

1. Hedge Funds Oversight – Final Report of the Technical Committee of IOSCO is available on IOSCO’s website.

2. Hedge Funds Oversight – Consultation Report of the Technical Committee of IOSCO was published on 30 April 2009.

3. IOSCO is recognized as the leading international policy forum for securities regulators. The organization’s wide membership regulates more than 95% of the world’s securities markets and IOSCO is the international cooperative forum for securities regulatory agencies. IOSCO members regulate more than one hundred jurisdictions and its membership is steadily growing.

4. The Technical Committee, a specialised working group established by IOSCO’s Executive Committee, is made up of eighteen agencies that regulate some of the worlds larger, more developed and internationalized markets. Its objective is to review major regulatory issues related to international securities and futures transactions and to coordinate practical responses to these concerns. Ms. Kathleen Casey, Commissioner of the United States Securities and Exchange Commission is the Chairman of the Technical Committee. The members of the Technical Committee are the securities regulatory authorities of Australia, Brazil, China, France, Germany, Hong Kong, India, Italy, Japan, Mexico, the Netherlands, Ontario, Quebec, Spain, Switzerland, United Kingdom and the United States.

5. IOSCO aims through its permanent structures:

  • to cooperate together to promote high standards of regulation in order to maintain just, efficient and sound markets;
  • to exchange information on their respective experiences in order to promote the development of domestic markets;
  • to unite their efforts to establish standards and an effective surveillance of international securities transactions;
  • to provide mutual assistance to promote the integrity of the markets by a rigorous application of the standards and by effective enforcement against offenses.

MEDIA ENQUIRIES
Greg Tanzer
Direct Line + 34 91 417 5549
Email: [email protected]
Website: www.iosco.org

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