Hedge fund regulation and the SEC

By Peter O’Dwyer, Hainault Capital Limited, Dublin, Ireland (22/01/2007)


IN THE PAST three years there has been much debate and discussion surrounding hedge funds and in particular the SEC's attempts at their regulation in the US. This forms part of the now ubiquitous clamour of comment on hedge funds which has not been limited to the specialist press. Much of this discussion, unfortunately, brings to mind the old analogy of the drunk and the lamppost, where the latter is used by the former more for support than illumination.

We know hedge funds have achieved cult status when Jeremy Clarkson can declare, "I have no idea what a hedge fund is, but after a day trip to Mustique, I think I need to plant one." (Sunday Times 23 April 2006).


Over the past 35 years the US Securities and Exchange Commission (SEC), has periodically conducted or participated in studies on hedge funds. In 1969 the Commission estimated that there were 200 hedge funds in existence with total assets of US$1.5 billion. In 1991, following admission by Salomon Brothers of irregularities in T bill auctions, an investigation concluded that no legislative changes with respect to hedge funds were required.

In a later report to Congress in 1992, the SEC admitted that it had limited information in relation to hedge funds. It stated, however, that the Commission was less concerned with issues around the protection of hedge fund investors and more with the impact hedge funds could have on the equity markets due to their size and presence, ie, the 'systemic risk'. At that time, the chairman of the US Federal Reserve, Alan Greenspan, publicly appeared less concerned and indicated his support for hedge funds, primarily because of their ability to provide liquidity and enhance markets.

Following the infamous collapse of the Connecticut based Long Term Capital Markets in 1998, the President's Working Group on Financial Markets looked at hedge funds and in particular the exposure of the banking sector to highly leveraged hedge fund counterparties. Significantly, the Working Group recommended in its report that no changes be made to the exemptions for hedge funds under the Investment Companies Act and the Investment Advisers Act. These two acts, dating from 1940, control the mutual fund industry in the United States. The Working Group took the position that the registration of hedge funds and their advisers at that time did not appear a useful method of monitoring hedge fund activity.

SEC fact-finding

In June 2002 the commissioners requested the SEC Staff to conduct a fact-finding mission aimed at reviewing the operations and practices of hedge funds. While recognising that hedge funds represented only a small portion of total US financial markets, the Commission was interested in hedge funds because of their significant growth and also because of the SEC's admission of its lack of information on this area. While various estimates of the size of the market existed at that time, the Staff's subsequent report put the then size of the US market at 6,000 to 7,000 funds with approximately US$650 billion in assets. To put this in context, the total market value of equities in the US stock market at the end of 2002 was US$11.8 trillion. The total size of the US mutual fund market was estimated at US$7 trillion.

The study commenced with the Staff's review of 65 hedge fund advisers, both registered and unregistered, managing over US$160 billion in assets. The Staff also met with broker dealers providing prime brokerage services, registered funds of hedge funds, advisers, investors and other observers willing to share information on hedge funds.

In May 2003 a Hedge Fund Roundtable was held, where a broad spectrum of the hedge fund industry and other interested people met to discuss hedge fund issues. At the conclusion of the Roundtable, the then chairman of the SEC, William Donaldson, requested his Staff to draw up a report and also invited public comment. The Staff Report involved a number of divisions of the SEC and was lead by Elisabeth Osterman, Assistant Chief Counsel. Ms Osterman was previously the Assistant Director for Investment Company Regulation and before that Assistant Director with the Office of Enforcement Liaison and therefore came to the report with strong regulatory and compliance credentials.

The Staff Report

The Staff Report entitled 'Implications of the Growth of Hedge Funds' was published on 29 September 2003. The report was broken down into a detailed summary of general industry information, which included descriptions of typical hedge fund strategies and structures. This was followed by the Staff's concerns and then recommendations. The scope of the report specifically excluded private equity, venture capital and commodity funds.

The concerns

The report noted that the study was in large part conducted because of the recognition by the SEC that it lacked information about hedge fund advisers and their trading strategies, because they were not obliged to register with the Commission. Although hedge fund advisers were subject to general federal anti-fraud legislation, they were not subject to any standardised reporting, or disclosure requirements, nor were they subject to SEC examination.

It is worth pointing out that this lack of supervision is largely confined to the United States, as in most other countries hedge fund managers are supervised.

The Commission was concerned about its inability to monitor and assess the impact of hedge funds on the wider financial markets and also to monitor and regulate the information which hedge funds provided to investors in order to enable them to make fully informed investment decisions. The Staff felt that this situation had the direct effect of putting the Commission in a 'wait and see' posture vis-à-vis fraud and other misconduct, whereas a systematic regime of examination would enable the SEC to identify misconduct earlier and assist in identifying and possibly preventing certain misconduct developing into fraud.

The Report also identified concerns in relation to the valuation of assets and liabilities in hedge funds. The discretion granted to advisers gave rise to questions as to whether the funds were accurately valued and it was felt that this had repercussions for registered funds, which themselves invest in hedge funds (funds of hedge funds). Such funds might not be able to properly 'fairly value' their investments and so accurately calculate their own net asset values.

One of the reasons why hedge funds do not fall within the regulatory regime of the 1940 Acts is that they are not marketed to the public and have historically been confined to high net worth investors, as defined under US regulations and to institutions.

The recommendations

The principal recommendation of the Staff Report was to introduce a requirement for hedge fund advisers to register with the SEC. Other significant recommendations related to the information to be provided to investors and the valuation methods adapted by funds of hedge funds. The most noticeable and controversial effect of the proposals was a suggested increase in the number of advisers required to register. Previously, where less than 15 US investors were clients of an adviser, the adviser was not required to register. Importantly, a fund was classed as one client. The proposed change had the effect of looking through the fund to the underlying investors and thus increased significantly the number of investment advisers who would be required to register.

The Report also made three technical suggestions that:

1. the Commission should consider addressing certain valuation, suitability and fee disclosure issues relating to registered funds of hedge funds;

2. the Commission should consider permitting general solicitation in fund offerings limited to qualified purchasers (ie, allow limited marketing); and

3. capital introduction services provided by broker dealers should be monitored.

Two other general "motherhood" recommendations of the report were that:

  • the Commission should encourage the hedge fund industry to embrace and further develop best practices; and
  • the Commission should continue its efforts to improve investor education regarding hedge funds.

The response

The initial response within the industry to the Staff Report was a general feeling that hedge funds were now going to become substantially more regulated than in the past.

It was felt that the expansion of the look through requirement for investment advisers, for example, could have the effect that not only many non-US investment advisers, but also the non-US management companies of hedge funds themselves would now become subject to SEC registration. This view was also confirmed by the SEC.

However, it was by no means all plain sailing for the Staff Report and there was a concerted attempt at row back on the part of certain elements in the United States. Two of the SEC Commissioners, Cynthia Glassman and Paul Atkins publicly criticised the Report and members of the President's Working Group, including John Snow, the secretary of the Treasury and James Newsome, chairman of the Commodity Futures Trading Commission who were reported to be opposed to the new rules. This left only the fourth member of the group, the then SEC chairman William Donaldson in favour, as Mr Greenspan had repeated his 1992 support for the non-regulation of the hedge fund industry in testimony to the Senate Banking Committee in February 2004.

SEC adopts registration rules

Notwithstanding the widespread opposition, in December 2004 the SEC, with strong support from Mr Donaldson, published in final form new rules governing its decision to commence the registration of hedge fund advisers.

These rules largely follow the draft set which was approved by the SEC on a three to two majority vote of the Commissioners on 26 October 2004. The acrimony at the top was reflected in the unusual inclusion in the 160 page release from the SEC of 30 pages of a dissenting opinion from Commissioners Cynthia Glassman and Paul Atkins who stated: "We hoped that the Commission would accord serious consideration to objections to their proposal.  Today's rulemaking, which is the wrong solution to an unidentified problem, disappoints those hopes and leaves better solutions unexplored."

The new rules came into effect from 10 February 2005 and required certain hedge fund managers to register with the SEC by 1 February 2006. A new adopted Rule 203 (b)(3)-2 required the investment adviser of any 'private fund' as defined to count as a single client each investor in the fund. The effect of this rule was to require advisers to hedge funds having in aggregate 15 or more individual US investors to register with the SEC. Prior to this an investment adviser could count a pooled investment vehicle, such as a hedge fund, as a single client. Accordingly, an adviser could manage up to 14 hedge funds without being required to register with the SEC.

Of most interest to the international fund industry was the extension of the SEC's registration requirements to non- US advisers. While the SEC somewhat patronisingly 'allowed' the advisers to disregard non-US investors for the purposes of the 15 investor test, on the other hand a US$25 million minimum NAV exclusion for US investment advisers did not apply to non-US advisers.

This meant that all non-US investment advisers were required to register if there were more than 14 US investors, whereas their US counterparts could not register unless they managed at least US$25 million. The new rules also exempted from the registration requirements any publicly offered overseas registered fund, which initially sounded good, until you read the small print, where it stated that where a hedge fund was publicly offered, the SEC reserved to itself the decision as to whether such a fund was in fact a public investment vehicle for the purposes of the rule.

Under the so-called 'registration lite', for non-US advisers certain requirements of the rules (eg, those concerning the appointment of compliance officers) were disapplied, although overseas advisers were still required to register with the SEC, to make available records pertaining to US clients and to be subject to SEC inspection.

As mentioned, most non-US hedge fund managers were already regulated in their home jurisdictions. While the SEC had considered this, it decided that it would not rely on such regulation, but would in certain instances, eg, with the UK's FSA, be prepared to conduct joint inspections. European cynics noted this as indicating that the SEC was attempting to piggy back on other regulators to make up for their own lack of knowledge.

Goldstein vs SEC

In early 2006, therefore, non-US hedge fund managers began to register with the SEC. While they were awaiting their first phone calls from Washington, however, an unexpected development occurred. In December 2004, a hedge fund manager, Phillip Goldstein from Pleasantville, New York, had taken a case against the SEC, alleging that the new regulations were a breach of the SEC's powers and in fact couldn't be enacted without new legislation passed by Congress.

As the case proceeded through the courts in early 2006, rumours began to circulate that against the odds, Mr Goldstein was going to win. During early depositions the judges of the DC Circuit Court were withering in their criticism of the SEC, stating that the Commission could not just say: "We will make a client whoever we want it to be."

On 23 June 2006, the Court decided that the SEC regulations should be struck down. In the ensuing vacuum the American Bar Association requested and received from the SEC a general no-action letter in August 2006.

While initially the hedge fund industry in general welcomed the Goldstein judgement, on reflection many are now concerned as to what might replace the SEC's aborted efforts. The President's Commission has been recalled to consider what should happen next, which is fine in itself.

However, in election season in the US, some states have now caught the hedge fund bug. Connecticut's attorney general, Richard Blumenthal (no doubt inspired by the electoral success of his former colleague, Elliot Spiter, in the neighbouring state) has jumped on the hedge fund bandwagon by establishing a local Connecticut Hedge Fund Task Force. The prospect of the SEC's botched initiative being replaced by 50 individual state mini-regulations is a horrifying prospect for the industry.

In the United States advisers who have already gone to the time and expense of registering are largely maintaining their registration. For non-US advisers, who are already regulated in their home jurisdictions, however, many are considering deregistering. Non- US investment advisers, who wish to deregister should, however, do so before February 2007, as after that date they will have to file financial statements with the SEC on deregistration. They must also maintain their books and records for five years post deregistration.

Where to now?

Several suggestions have been made as to where the US will go next in this area and the political colour of the next President may be a determining factor. It may be that the Federal Reserve will seek quarterly reporting from hedge funds. Another suggestion is that prime brokers and other regulated counterparties will be restricted in their dealings with unregistered entities.

There is no doubt, however, that the reason for all this heat and very little light has been that in the United States a practice which was allowed to develop, whereby hedge funds grew up as an unregulated cottage industry, with little or no supervision. In correcting a uniquely American problem, the SEC went extraterritorial and thus into countries with infinitely more regulation. It is to be hoped (probably in vain) that the United States authorities now concentrate on sorting out their own backyard first, before troubling overseas investment managers again.