SEC Supports Private Funds Transparency Act of 2009

Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools

The SEC released a testimony from Andrew J. Donohue before the U.S. Senate about the regulation of hedge funds and other private investment pools. According to Mr. Donohue’s statement, securities laws have not kept pace with the growth market and thus the SEC has very little oversight authority over these advisors and private funds with regards to conducting compliance examinations, obtaining material information, etc primarily because these requirements only apply to those advisors and entities registered with the SEC. Because advisors to private funds have the option to ‘opt out’ of registration, they can easily bypass any monitoring and oversight. The Commission strongly supports the enforcement of the new Private Funds Transparency Act of 2009,* which attempts to close this regulatory gap by requiring advisors to private funds to register under the Advisers Act if they have at least $30 million of assets under management. The Commission also notes that in order to be effective, the new regulatory reform should acknowledge the differences in the business models pursued by different types of private fund advisers and should address in a proportionate manner the risks to investors and the markets raised by each.

The various compliance requirements on advisors to private funds as set forth by this new legislation is outlined in the testimony, reprinted in full below.

*Note: this testimony was given the same day that the Treasury announced the Private Fund Investment Advisers Registration Act of 2009 which is very similar to the Private Funds Transparency Act of 2009.

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Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools
by Andrew J. Donohue
Director, Division of Investment Management
U.S. Securities and Exchange Commission

Before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs
July 15, 2009

Chairman Reed, Ranking Member Bunning and Members of the Subcommittee:

I. Introduction

Thank you for the opportunity to testify before you today. My name is Andrew Donohue, and I am the Director of the Division of Investment Management at the Securities and Exchange Commission. I am pleased to testify on behalf of the Commission about regulating hedge funds and other private investment pools.1

Over the past two decades, private funds, including hedge, private equity and venture capital funds, have grown to play an increasingly significant role in our capital markets both as a source of capital and the investment vehicle of choice for many institutional investors. We estimate that advisers to hedge funds have almost $1.4 trillion under management. Since many hedge funds are very active and often leveraged traders, this amount understates their impact on our trading markets. Hedge funds reportedly account for 18-22 percent of all trading on the New York Stock Exchange. Venture capital funds manage about $257 billion of assets,2 and private equity funds raised about $256 billion last year.3

The securities laws have not kept pace with the growth and market significance of hedge funds and other private funds and, as a result, the Commission has very limited oversight authority over these vehicles. Sponsors of private funds—typically investment advisers—are able to organize their affairs in such a way as to avoid registration under the federal securities laws. The Commission only has authority to conduct compliance examinations of those funds and advisers that are registered under one of the statutes we administer. Consequently, advisers to private funds can “opt out” of Commission oversight.

Moreover, the Commission has incomplete information about the advisers and private funds that are participating in our markets. It is not uncommon that our first contact with a manager of a significant amount of assets is during an investigation by our Enforcement Division. The data that we are often requested to provide members of Congress (including the data we provide above) or other federal regulators are based on industry sources, which have proven over the years to be unreliable and inconsistent because neither the private funds nor their advisers are required to report even basic census-type information.

This presents a significant regulatory gap in need of closing. The Commission tried to close the gap in 2004—at least partially—by adopting a rule requiring all hedge fund advisers to register under the Investment Advisers Act of 1940 (“Advisers Act”).4 That rulemaking was overturned by an appellate court in the Goldstein decision in 2006.5 Since then, the Commission has continued to bring enforcement actions vigorously against private funds that violate the federal securities laws, and we have continued to conduct compliance examinations of the hedge fund advisers that remain registered under the Advisers Act. But we only see a slice of the private fund industry, and the Commission strongly believes that legislative action is needed at this time to enhance regulation in this area.

The Private Fund Transparency Act of 2009, which Chairman Reed recently introduced, would require advisers to private funds to register under the Advisers Act if they have at least $30 million of assets under management.6 This approach would provide the Commission with needed tools to provide oversight of this important industry in order to protect investors and the securities markets. Today, I wish to discuss how registration of advisers to private funds under the Advisers Act would greatly enhance the Commission’s ability to properly oversee the activities of private funds and their advisers. Although the Commission supports this approach, there are additional approaches available to that also would close the regulatory gap and provide the Commission with tools to better protect both investors and the health of our markets.

II. The Importance and Structure of Private Funds

Private funds are generally considered to be professionally managed pools of assets that are not subject to regulation under the Investment Company Act of 1940 (“Investment Company Act”). Private funds include, but are not limited to, hedge funds, private equity funds and venture capital funds.

Hedge funds pursue a wide variety of strategies that typically involve the active management of a liquid portfolio, and often utilize short selling and leverage.

Private equity funds generally invest in companies to which their advisers provide management or restructuring assistance and utilize strategies that include leveraged buyouts, mezzanine finance and distressed debt. Venture capital funds typically invest in earlier stage and start-up companies with the goal of either taking the company public or privately selling the company. Each type of private fund plays an important role in the capital markets. Hedge funds are thought to be active traders that contribute to market efficiency and enhance liquidity, while private equity and venture capital funds are seen as helping create new businesses, fostering innovation and assisting businesses in need of restructuring. Moreover, investing in these funds can serve to provide investors with portfolio diversification and returns that may be uncorrelated or less correlated to traditional securities indices.

Any regulatory reform should acknowledge the differences in the business models pursued by different types of private fund advisers and should address in a proportionate manner the risks to investors and the markets raised by each.

III. Current Regulatory Exemptions

Although hedge funds, private equity funds and venture capital funds reflect different approaches to investing, legally they are indistinguishable. They are all pools of investment capital organized to take advantage of various exemptions from registration. All but one of these exemptions were designed to achieve some purpose other than permitting private funds to avoid oversight.

A. Securities Act of 1933

Private funds typically avoid registration of their securities under the Securities Act of 1933 (Securities Act) by conducting private placements under section 4(2) and Regulation D.7 As a consequence, these funds are sold primarily to “accredited investors,” the investors typically receive a “private placement memorandum” rather than a statutory prospectus, and the funds do not file periodic reports with the Commission. In other words, they lack the same degree of transparency required of publicly offered issuers.

B. Investment Company Act of 1940

Private funds seek to qualify for one of two exceptions from regulation under the Investment Company Act of 1940 (Investment Company Act). They either limit themselves to 100 total investors (as provided in section 3(c)(1)) or permit only “qualified purchasers” to invest (as provided in section 3(c)(7)).8 As a result, the traditional safeguards designed to protect retail investors in the Investment Company Act are the subject of private contracts for investors in private funds. These safeguards include investor redemption rights, application of auditing standards, asset valuation, portfolio transparency and fund governance. They are typically included in private fund partnership documents, but are not required and vary significantly among funds.

C. Investment Advisers Act of 1940

The investment activities of a private fund are directed by its investment adviser, which is typically the fund’s general partner.9 Investment advisers to private funds often claim an exemption from registration under section 203(b)(3) of the Advisers Act, which is available to an adviser that has fewer than 15 clients and does not hold itself out generally to the public as an investment adviser.

Section 203(b)(3) of the Advisers Act contains a de minimis provision that we believe originally was designed to cover advisers that were too small to warrant federal attention. This exemption now covers advisers with billions of dollars under management because each adviser is permitted to count a single fund as a “client.” The Commission recognized the incongruity of the purpose of the exemption with the counting rule, and adopted a new rule in 2004 that required hedge fund advisers to “look through” the fund to count the number of investors in the fund as clients for purposes of determining whether the adviser met the de minimis exemption. This was the rule overturned by the appellate court in the Goldstein decision. As a consequence, approximately 800 hedge fund advisers that had registered with the Commission under its 2004 rule subsequently withdrew their registration.

All advisers to private funds are subject to the anti-fraud provisions of the Investment Advisers Act, including an anti-fraud rule the Commission adopted in response to the Goldstein decision that prohibits advisers from defrauding investors in pooled investment vehicles.10 Registered advisers, however, are also subject to periodic examination by Commission staff. They are required to submit (and keep current) registration statements providing the Commission with basic information, maintain business records for our examination, and comply with certain rules designed to prevent fraud or overreaching by advisers. For example, registered advisers are required to maintain compliance programs administered by a chief compliance officer.

IV. Options to Address the Private Funds Regulatory Gap11

As discussed below, though there are different regulatory approaches to private funds available to Congress, or a combination of approaches, no type of private fund should be excluded from any new oversight authority any particular type of private fund. The Commission’s 2004 rulemaking was limited to hedge fund advisers. However, since that time, the lines which may have once separated hedge funds from private equity and venture capital funds have blurred, and the distinctions are often unclear. The same adviser often manages funds pursuing different strategies and even individual private funds often defy precise categorization. Moreover, we are concerned that in order to escape Commission oversight, advisers may alter fund investment strategies or investment terms in ways that will create market inefficiencies.

A. Registration of Private Fund Investment Advisers

The Private Funds Transparency Act of 2009 would address the regulatory gap discussed above by eliminating Section 203(b)(3)’s de minimis exemption from the Advisers Act, resulting in investment advisers to private funds being required to register with the Commission. Investment adviser registration would be beneficial to investors and our markets in a several important ways.

1. Accurate, Reliable and Complete Information

Registration of private fund advisers would provide the Commission with the ability to collect data from advisers about their business operations and the private funds they manage. The Commission and Congress would thereby, for the first time have accurate, reliable and complete information about the sizable and important private fund industry which could be used to better protect investors and market integrity. Significantly, the information collected could include systemic risk data, which could then be shared with other regulators.12

2. Enforcement of Fiduciary Responsibilities

Advisers are fiduciaries to their clients. Advisers’ fiduciary duties are enforceable under the anti-fraud provisions of the Advisers Act. They require advisers to avoid conflicts of interest with their clients, or fully disclose the conflicts to their clients. Registration under the Advisers Act gives the Commission authority to conduct on-site compliance examinations of advisers designed, among other things, to identify conflicts of interest and determine whether the adviser has properly disclosed them. In the case of private funds, it gives us an opportunity to determine facts that most investors in private funds cannot discern for themselves. For example, investors often cannot determine whether fund assets are subject to appropriate safekeeping or whether the performance represented to them in an account statement is accurate. In this way, registration may also have a deterrent effect because it would increase an unscrupulous adviser’s risk of being discovered.

A grant of additional authority to obtain information from and perform on-site examinations of private fund advisers should be accompanied with additional resources so that the Commission can bring to bear the appropriate expertise and technological support to be effective.

3. Prevention of Market Abuses

Registration of private fund advisers under the Advisers Act would permit oversight of adviser trading activities to prevent market abuses such as insider trading and market manipulation, including improper short-selling.

4. Compliance Programs

Private fund advisers registered with the Commission are required to develop internal compliance programs administered by a chief compliance officer. Chief compliance officers help advisers manage conflicts of interest the adviser has with private funds. Our examination staff resources are limited, and we cannot be at the office of every adviser at all times. Compliance officers serve as the front-line watch for violations of securities laws, and provide protection against conflicts of interests.

5. Keeping Unfit Persons from Using Private Funds to Perpetrate Frauds

Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or engaged in securities fraud.

6. Scalable Regulation

In addition, many private fund advisers have small to medium size businesses, so it is important that any regulation take into account the resources available to those types of businesses. Fortunately, the Advisers Act has long been used to regulate both small and large businesses, so the existing rules and regulations already account for those considerations. In fact, roughly 69 percent of the investment advisers registered with the Commission have 10 or fewer employees.

7. Equal Treatment of Advisers Providing Same Services

Under the current law, an investment adviser with 15 or more individual clients and at least $30 million in assets under management must register with the Commission, while an adviser providing the same advisory services to the same individuals through a limited partnership could avoid registering with the Commission. Investment adviser registration in our view is appropriate for any investment adviser managing $30 million regardless of the form of its clients or the types of securities in which they invest.

B. Private Fund Registration

Another option to address the private fund regulatory gap might be to register the funds themselves under the Investment Company Act (in addition to registering their advisers under the Advisers Act). Alternatively, the Commission could be given stand-alone authority to impose requirements on unregistered funds. Through direct regulation of the funds, the Commission could impose, as appropriate, investment restrictions or diversification requirements designed to protect investors. The Commission could also regulate the structure of private funds to protect investors (such as requiring an independent board of directors) and could also regulate investment terms (such as protecting redemption rights).

C. Regulatory Flexibility through Rulemaking Authority

Finally, there is third option that in conjunction with advisers’ registration may be necessary to address the regulatory gap in this area. Because it is difficult, if not impossible, to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as private funds, an additional option might be to provide the Commission with the authority that allows for additional regulatory flexibility to act in this area. This could be done by providing rule-making authority to condition the use by a private fund of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. These conditions could impose those requirements that the Commission believes are necessary or appropriate to protect investors and enhance transparency.13 In many situations, it may be appropriate for these requirements to vary depending upon the type of fund involved. This would enable the Commission to better discharge its responsibilities and adapt to future market conditions without necessarily subjecting private funds to Investment Company Act registration and regulation.

V. Conclusion

The registration and oversight of private fund advisers would provide transparency and enhance Commission oversight of the capital markets. It would give regulators and Congress, for the first time, reliable and complete data about the impact of private funds on our securities markets. It would give the Commission access to information about the operation of hedge funds and other private funds through their advisers. It would permit private funds—which play an important role in our capital markets—to retain the current flexibility in their investment strategies.

The Commission supports the registration of private fund advisers under the Advisers Act. The other legislative options I discussed above, namely registration of private funds under the Investment Company Act and/or providing the Commission with rulemaking authority in the Investment Company Act exemptions on which private funds rely, should also be weighed and considered as the Subcommittee considers approaches to filling the gaps in regulation of pooled investment vehicles.

I would be happy to answer any questions you may have.

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Endnotes:

1 Commissioner Paredes does not endorse this testimony.

2 The National Venture Capital Association (NVCA) estimates that 741 venture capital firms and 1,549 venture capital funds were in existence in 2007, with $257.1 billion in capital under management. NVCA, Yearbook 2008 at 9 (2008). In 2008, venture capital funds raised $28.2 billion down from $35.6 billion in 2007. Thomson Reuters & NVCA, News Release (Apr. 13 2009). In 2007, the average fund size was $166 million and the average firm size was $347 million. Id. at 9.

3 U.S. private equity funds raised $256.9 billion in 2008 (down from $325.2 billion in 2007). Private Equity Analyst, 2008 Review and 2009 Outlook at 9 (2009) (reporting Dow Jones LP Source data.

4 Investment Advisers Act Release No. 2333 (Dec. 2, 2004).

5 See Goldstein v. S.E.C., 451 F.3d 873 (D.C. Cir. 2006).

6 Section 203A(a)(1) of the Act prohibits a state-regulated adviser to register under the Act if it has less than $25 million of assets under management. The Commission has adopted a rule increasing the $25 million threshold to $30 million. See Rule 203A-1 under the Advisers Act. The threshold does not apply to foreign advisers. Section 3 of the Private Fund Transparency Act would establish a parallel registration threshold for foreign advisers, which would prevent numerous smaller foreign advisers that today rely on the de minimis exception, which the Act would repeal, from being required to register with the Commission.

7 Section 4(2) of the Securities Act of 1933 provides an exemption from registration for transactions by the issuer of a security not involving a public offering. Rule 506 of Regulation D provides a voluntary “safe harbor” for transactions that are considered to come within the general statutory language of section 4(2).

8 “Qualified purchasers” generally are individuals or family partnerships with at least $5 million in investable assets and companies with at least $25 million. The section 3(c)(7) exception was added in 1996 and specifically anticipated use by private funds.

9 Private funds often are organized as limited partnerships with the fund’s investment adviser serving as the fund’s general partner. The fund’s investors are limited partners of the fund.

10 See Rule 206(4)-8 under the Advisers Act.

11 Commissioner Casey does not endorse the approaches discussed in sections IV. B and C.

12 The Private Fund Transparency Act includes some important although technical amendments to the Advisers Act that are critical to the Commission’s ability to collect information from advisers about private funds, including amendments to Section 204 of the Act permitting the Commission to keep information collected confidential, and amendments to Section 210 preventing advisers from keeping the identity of private fund clients from our examiners.

13 For example, private funds might be required to provide information directly to the Commission. These conditions could be included in an amendment to the Investment Company Act or could be in a separate statute.

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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:

Series 79 Exam – Waiting for SEC Approval

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Post courtesy of www.series79exam.com.

SEC to Shed Light on the New Series 79 Exam

Pursuant to a proposal set forth by FINRA in February of this year, it is anticipated that the Series 79 will be introduced as a simplified alternative exam for investment bankers. Prior to the introduction of this new exam, all registered representatives were required by NASD Rule 1032 to take the Series 7 exam. The proposal modified this Rule to condense the exam for those individuals whose activities are limited to investment banking. The primary reason behind the FINRA proposal for a new abridged exam was that the Series 7 exam covers a broad array of functions that do not pertain to the day-to-day activities of an investment banker.

On July 13, 2009 we contacted FINRA to determine what information, if any, has been released on the new Series 79 exam. According to FINRA, the SEC has approved the proposal set forth by FINRA as of April of this year, but SEC approval on the content of the exam and related fees is still pending. Thus, there is limited information available to prospective exam takers regarding the proposed content of the exam, the timeline for required registration, the release of related study materials and/or course offerings, and related exam fees. Once the SEC issues its approval, a formal press release will be issued to the public regarding the structure of the exam as well as an expected date as to when the modified NASD Rule 1032(i) will be enforced, thereby establishing the Series 79 as the new license requirement for investment bankers.

All information regarding the Series 79 Exam will be available on this site for prospective exam takers once it is formally approved by the SEC.

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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:

Private Fund Investment Advisers Registration Act of 2009

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

****UPDATE 10/27/2009****

The House Financial Services Committee voted on October 27, 2009 to pass the Private Fund Investment Advisers Registration Act of 2009 as H.R. 3818 (full text of bill as passed – please note that it is different from the earlier version of the bill reprinted below). The bill as passed by the committee required private equity fund managers to register but specifically excludes managers of venture capital funds from the registration requirements. The House Committee released a press release discussing the bipartisan vote.

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Text of Private Fund Investment Advisers Registration Act of 2009

Today the Obama Administration released its proposed legislation which would require hedge fund managers to register with the SEC (as well as private equity fund and venture capital fund managers). The full text of the Private Fund Investment Advisers Registration Act of 2009 has been copied below.

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TITLE IV—REGISTRATON OF ADVISERS TO PRIVATE FUNDS

SEC. 401. SHORT TITLE.

This Act may be cited as the “Private Fund Investment Advisers Registration Act of 2009”.

SEC. 402. DEFINITIONS.

Section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following:

“(29) The term ‘private fund’ means an investment fund that—

“(A) would be an investment company (as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3)), but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) or 80a-3(c)(7)); and

“(B) either—

“(i) is organized or otherwise created under the laws of the United States or of a State; or

“(ii) has 10 percent or more of its outstanding securities owned by U.S. persons.

“(30) The term ‘foreign private adviser’ means any investment adviser who—

“(A) has no place of business in the United States;

“(B) during the preceding 12 months has had—

“(i) fewer than 15 clients in the United States; and

“(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

“(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53), and has not withdrawn its election.”.

SEC. 403. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS; LIMITED INTRASTATE EXEMPTION.

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

(a) in paragraph (1), by inserting “, except an investment adviser who acts as an investment adviser to any private fund,” after “investment adviser” the first time it appears;

(b) by amending paragraph (3) to read as follows:

“(3) any investment adviser that is a foreign private adviser;”; and

(1) in subparagraph (A), by striking “or”;

(2) in subparagraph (B), by striking the period at the end and adding “; or”; and

(3) by adding at the end the following new subparagraph:

“(C) a private fund.”

SEC. 404. COLLECTION OF SYSTEMIC RISK DATA; REPORTS; EXAMINATIONS; DISCLOSURES.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended—

(a) by redesignating subsections (b) and (c) as subsections (c) and (d); and

(b) by inserting after subsection (a) the following new subsection (b):

“(b) RECORDS AND REPORTS OF PRIVATE FUNDS.—

“(1) IN GENERAL.—The Commission is authorized to require any investment adviser registered under this Act to maintain such records of and submit to the Commission such reports regarding private funds advised by the investment adviser as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council, and to provide or make available to the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council those reports or records or the information contained therein. The records and reports of any private fund would be an investment company, to which any such investment adviser provides investment advice, maintained or filed by an investment adviser registered under this Act shall be deemed to be the records and reports of the investment adviser.

“(2) REQUIRED INFORMATION.—The records and reports required to be filed with the Commission under this subsection shall include but shall not be limited to the following information for each private fund advised by the investment adviser:

“(A) amount of assets under management, use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading and

investment positions, and trading practices; and

“(B) such other information as the Commission, in consultation with the Board of Governors of the Federal Reserve System, determines necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(3) MAINTENANCE OF RECORDS.—An investment adviser registered under this Act is required to maintain and keep such records of private funds advised by the investment adviser for such period or periods as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(4) EXAMINATION OF RECORDS.—

“(A) PERIODIC AND SPECIAL EXAMINATIONS.—All records of a private fund maintained by an investment adviser registered under this Act shall be subject at any time and from time to time to such periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe.

“(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this Act shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense or delay as the Commission or its representatives may reasonably request.

“(5) INFORMATION SHARING.— The Commission shall make available to the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council copies of all reports, documents, records and information filed with or provided

to the Commission by an investment adviser under section 204(b) as the Board or the Council may consider necessary for the purpose of assessing the systemic risk of a private fund or assessing whether a private fund should be designated a Tier 1 financial holding company. All such reports, documents, records and information obtained by the Board or the Council from the Commission under this subsection shall be kept confidential.

“(6) DISCLOSURES BY PRIVATE FUND.—An investment adviser registered under this Act shall provide such reports, records and other documents to investors, prospective investors, counterparties, and creditors, of any private fund advised by the investment adviser as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(7) CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any supervisory report or information contained therein required to be filed with the Commission under subsection (b). Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this subsection shall be considered a statute described in subsection (b)(3)(B) of such section 552.”.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 406. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended—

(1) in subsection (a)—

(A) by striking the second sentence; and

(B) by striking the period at the end of the first sentence and inserting the following:

“, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may—

“(1) classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters; and

“(2) ascribe different meanings to terms (including the term ‘client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.”; and

(2) by adding at the end the following new subsection:

“(e) The Commission and the Commodity Futures Trading Commission shall, after consultation with the Board of Governors of the Federal Reserve System, within 6 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2009, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under subsection 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under the Investment Advisers Act of 1940 (15 U.S.C. 80b et seq.) and the Commodity Exchange Act (7 U.S.C. 1a et seq.).”.

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Obama Moves Forward with Hedge Fund Registration Legislation

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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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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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Obama Administration Proposes New Regulatory Agency

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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

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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:

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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Hedge Fund PPIP Managers Selected

Net Capital Requirement for State Registered Hedge Fund Managers

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Overview of Net Capital Requirement and Bond Alternative

Hedge fund managers who need to register as investment advisors in their state of residence often have to deal with the net capital requirement issue. Usually there will be two separate net capital requirements for the investment advisor (meaning the fund’s management company) depending on the nature of the advisor’s business:

Advisors with Discretionary Authority – $10,000
Advisors with Custody – $35,000

[Note: these requirements do not usually apply to forex hedge fund managers unless such managers are also registered as investment advisors.]

Generally all state-registered hedge fund managers will have discretionary authority of the hedge fund’s investments so most advisors will need to maintain the $10,000 requirement. Also, most hedge fund managers will also be deemed to have “custody” of the fund assets because they will either have direct access to the hedge fund’s bank account or because they will directly deposit their management fees from the fund’s brokerage account. Accordingly, most state-registered hedge fund managers will need to maintain the more burdensome $35,000 net capital requirement. There is no requirement to combine the $10,000 with the $35,000 for managers with both discretionary authority and custody – in these situations the manager will only need to maintain the $35,000.

Investment Advisor Bond

As an alternative to maintaining a firm net capital according to the rules above, some states will allow hedge fund managers to post a bond in the required amount instead. Not all states will allow a manager to post a bond instead, so you should be sure to talk with your hedge fund attorney or compliance professional before you begin the process of securing a bond.

Securing the Bond

There are a number of groups out there that can underwrite these sorts of bonds for the money managers. The fees for such bonds will be anywhere from $250 to $1,000, depending on a number of factors including the credit history of the managing member of the fund management company. It will generally take anywhere from a few days to a couple of weeks to secure the bond and from there, the manager will likely need to show proof to the state securities division that the bond has been secured in the appropriate amount.

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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. Cole-Frieman & Mallon LLP will also help state based Investment Advisors to register with their state securities division. If you are a hedge fund manager who is looking to start a hedge fund or an investment advisor looking to register, please call Mr. Mallon directly at 415-296-8510.