At the end of October, the House Financial Services Committee moved forward on two of the topics previously tracked by this blog, and introduced a third into the discussion.

On the 27th, the Committee approved H.R. 3818, the Private Fund Investment Advisers Registration Act, which requires advisors to private pools of capital to register with the SEC, and subjects them to new recordkeeping and disclosure requirements.   The bill, a derivative of the proposed legislation submitted by the administration in July and discussed in a posting at that time, was introduced by Representative Paul Kanjorski on October 15. The markup draft does incorporate several material changes from the earlier proposal.

The next day the Committee approved H.R. 3890, the Accountability and Transparency in Rating Agencies Act.   This bill was also introduced by representative Kanjorski based on the administration’s proposed Improvements to Regulation the of Credit Rating Agencies that was discussed in this earlier post.

Both of these bills received strong bipartisan support in the Committee. Going forward, their progress can be tracked on the widgets to the left.

On the 27th, the Committee also began considering the Financial Stability Improvement Act, their version of an administration proposal to require financial firms, including hedge funds, with more than $10 billion in assets to cover the cost if the government takes over financial institutions whose failure could pose a systemic risk.   This bill is a compromise worked out between the Treasury Department and Committee Chairman Barney Frank.

All three of these developments and their potential impacts on the hedge fund industry will be discussed in greater detail in upcoming posts in our InDepth Section.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Evolutionary theory includes a vacant-niche hypothesis that new species sometimes arise when evolution fills a niche that had sufficient available resources but was not already been occupied by another organism.  Darwin’s observation of the evolution of finches to fill different available niches distributed among the Galapagos Islands was an example, as was the evolution of a number of Australian marsupials to resemble species that evolved elsewhere to fill comparable vacant-niches.

Similarly, the gap created by the combination of exemptions from registration under the 33 Act, the 34 Act, the Advisers Act, the Commodity Exchange Act (CEA), and the 40 Act created a opportunity rich vacant-niche that played a key role in the development of hedge funds. This article will analyze the substance of those exemptions, the application of each to hedge funds, and the ways in which they have determined some of the more distinctive structures and practices adopted as standard practice by the industry.  Other articles (or, more likely, a series of articles) will analyze the changes in such standard practices, as legislation limits or removes one or more of the exemptions.  To date, there are proposals by Congress and the Administration to close or limit the Advisers Act and 40 Act exemptions.

Without exemptions, a hedge fund and its adviser would be required to register under four or five statutes, depending on whether it invested in commodities.  Hedge funds are usually limited partnerships; ownership interests in LPs are classified as securities under the 33 Act, and so that Act would require registering the funds’ shares with the SEC before any sales or offers to sell, and the 34 Act would impose a registration requirement while the shares were outstanding.

As companies primarily engaged in the business of investing the pooled assets of investors in securities, hedge funds are investment companies as defined in the 40 Act and as such would be required to register under that Act, and as Commodity Pool Operators (CPOs) under the CEA if they trade instruments regulated by the CFTC. And finally, the management company directing investment of the funds is a business compensated for advising others concerning investments in securities, making it an investment adviser under the Advisers Act, and potentially a commodity trading adviser (CTA) under the CEA, each of which would require registration under the respective Act.

A simplified view of the general structure typically used to issue and manage hedge funds, and the corresponding exemptions from SEC registrations, is shown in the diagram below and in greater detail in the table at the end of this article.

Each of the five statutes, however, includes one or more exemptions from registration that were originally designed to limit their impact on firms presenting limited risk either because they were too small, or because they served clients who needed less protection. Each exemption was adopted independently, at different times and in statutes designed to address different issues.  The hedge fund industry has used them in combination to create a business niche that has enabled them to invest differently, and arguably more successfully, than registered firms while restricting the ability of registered firms to compete – in short, they’ve used them to create a fertile vacant-niche.

The relevant exemptions under the five Acts, and their application to hedge funds, are analyzed below.

Exemption from Registration under the 33 and 34 Acts

Investments in hedge funds usually take the form of purchases of limited partnership interests in the fund, which qualify as securities under the Securities Act of 1933 and the Securities Exchange Act of 1934.  The 33 Act can require the registration of securities at the time they are issued, while a 34 Act registration requirement can arise at any time while the securities are outstanding.

Section 5 of the 33 Act generally prohibits interstate sales of, or offers to sell, securities unless they have been registered with the SEC.  Section 4(2) of the Act, however, excepts “ transactions by an issuer not involving any public offering,” but does not provide added guidance as to what constitutes a “public offering.”

In a definitive 1953 case, SEC vs. Ralston Purina, the Supreme Court interpreted the provision based on the intent of the Act to find that the exemption applied where offerees (not just the purchasers) belonged to “the particular class of persons [that] needs the protection” of the Act.  Other, more sophisticated investors could be left to fend for themselves, provided they were given access to the kind of information found in a prospectus. Subsequently, the SEC clarified that the key factors to be considered in making the determination included the number and sophistication of the offerees, whether they were provided sufficient information to evaluate the offer, and whether there had been what could be deemed a “general solicitation” of purchasers.

Unfortunately, each of the factors applied to determining the applicability of Section 4(2) is open to interpretation, and no guidance was provided by the Court or the SEC for weighting the different factors to evaluate a planned issuance.

Starting in 1974 with Rule 146, the SEC promulgated several safe haven Rules designed to provide issuers with a practical basis for determining whether an exemption to the registration requirement would apply.  In 1982, the Commission consolidated these provisions into Regulation D, which continues to be relied upon to ensure hedge fund issuances qualify as non-public offerings.  Reg D includes several provisions for exempting limited-sized offerings, but most hedge funds rely on Rule 506, which does not restrict the dollar value or number of accredited purchasers in an offering.

To qualify for the Rule 506 exemption, however, fund shares can be sold to no more than 35 non-accredited purchasers.  Accredited Purchasers are defined by Rule 501 as banks, insurance companies, registered investment companies and other institutional investors, plus individuals who are in certain specified senior roles with the fund, or are investors who:

• Alone or with a spouse have a net worth over $1M, or
• Earned over $200K alone (or over $300K with a spouse) in the prior two years and reasonably expect to do so again during the year in which the shares are bought.

The limit on non-accredited investors is based on the status of the investors at the time of purchase, but must be applied cumulatively to all investors brought into the fund over its lifetime, not just to the investors in the fund at any one time.  At the time of their purchase, non-accredited investors must also qualify as sophisticated investors, having sufficient knowledge and experience (either personally or through a purchaser representative), and must be receive sufficient information from the issuer, to assess the value and risks of the offering, which has been interpreted to mean information comparable to that required in a registration statement.  As a result, many hedge funds elect not to sell to any non-accredited investors.

Though exempt from registration, funds relying upon the Reg D safe harbor are required to file a Form D notice with the SEC.

Even when securities issued by fund are exempt from registration when they’re issued, managers must avoid becoming obliged to register at a later time under Securities Exchange Act of 1934.  §12(g) of the 34 Act requires registration of shares of companies with more than $1M in assets and 500 or more shareholders, unless they registered as investment companies under the 40 Act – but 40 Act registration is even more burdensome, as discussed below.

Exemption from Registration under the Advisers Act and the CEA (as a CTA)

Besides the potential requirement to register hedge fund shares under the 33 and 34 Acts, a hedge fund adviser may be required to register with the SEC as an investment adviser under the Advisers Act or with the CFTC as a commodity trading adviser (CTA) under the CEA.

§202(a)(11) of the Advisers Act specifies that anyone who engages for compensation in the business of advising others as to the advisability of investing in securities is an investment adviser subject to the requirements of the Act and, absent an exemption, is required to register with the SEC.

Under §203(b)(3) of the Act, advisers are exempt from registration if during the preceding year they advised fewer than 15 investors, did not hold themselves out to the general public as investment advisers, and did not advise any investment companies.  For purposes of this exemption, a corporation, general partnership, limited partnership, limited liability company, or other legal organization is counted as a single investor if the advice provided was based on the investment objectives of the entity not the individual objectives of its owners or beneficiaries.

In 2004 the SEC amended Rule 203(b)(3)-1 and adopted Rule 203(b)(3)-2 to define “private funds,” and to establish procedures to look through them when counting clients for purposes of the §203(b)(3) exemption.  The definition of a private fund included the fund’s reliance on an exemption under §3(c)(1) or §3(c)(7) of the 40 Act, permitting investors to withdraw funds less than two years after their investment, and reliance on the investment skills of the adviser – all of which apply to most hedge funds.  Since this would push the majority of hedge fund advisers past the 15 investor limit, nearly 1,000 advisers did in fact register with the SEC pending the scheduled effectiveness of the amendment in 2006.

In its 2006 finding in Goldstein v. SEC, the DC Circuit Court overturned the private fund amendments, finding that the SEC lacked the authority to redefine the definition of a ‘client’ absent some motivating change in the market or legal environment.  Later that year the SEC released a no-action letter permitting advisers that had registered in preparation for the new Rules to withdraw their registrations in reliance on 203(b)(3).

As reflected in another article on this site, however, the amendments to the Advisers Act that were proposed by the Administration in July include a new registration requirement for private funds as well as an express grant to the SEC of the authority to interpret the term “client,” effectively overriding the Court’s finding in Goldstein. Although the proposal is still subject to revisions in Congress, it is widely expected that some amendment significantly expanding the requirement for hedge fund registration will be enacted.

Entities that advise collective investment vehicles concerning commodity interest trading generally are required to register as CTAs with the CFTC.  The CEA provides an exemption under §4m(1) that is similar to the exemption under §203(b)(3) of the Adviser’s Act, exempting from registration those who advised fewer than 15 clients during the preceding year, provided that they did not hold themselves out to the public as CTAs.  In 2003, the CFTC adopted Rule 4.14(a)(10) under which advisers the CFTC will count a fund as a single client when it has been advised based on the interests of the fund, not those of its individual investors.  Prior to adopting Rule 4.14(a)(10), the CFTC had looked through funds to count the funds’ investors as the SEC proposed to do prior to Goldstein.

A second exemption applies to those advisers already registered with the SEC as investment advisers, provided advice regarding commodity interests is not their primary activity and they do not advise any entities whose primarily businesses are trading commodities for future delivery on contract markets.

Advisers claiming an exemption from registering with the CFTC under either provision still must file a notice with the National Futures Association.

Exemption from Registration under the 40 Act and the CEA (as a CPO)

Finally, hedge fund managers generally take advantage of exemptions that allow them to avoid registering the hedge funds themselves with the SEC as investment companies under the 40 Act, or with the CFTC and NFA as a commodity pool operators (CPOs) under the CEA.

Under the 40 Act, companies are deemed to be investment companies if they primarily engage in the business of investing, reinvesting, or trading in securities, or hold themselves out as being in such businesses. The Act requires investment companies to register with the SEC before offering securities, including their own ownership interests, for sale or otherwise engaging in any business in interstate commerce unless they are entitled to claim an exemption from registration.

Section 3(C)(1) provides an exemption for small funds that are not publicly offered. Under this provision, a hedge fund will not be considered an investment company, and therefore will not be required to register as such, if its outstanding shares are beneficially owned by one hundred or fewer persons and it does not make, or presently propose to make, a public offering of its securities.  In applying this limit, corporate investors are generally counted as one person.   To prevent layering of ownership to avoid registering, the SEC will look through any companies that own the securities of the fund if they are investment companies themselves (or would be except for an exemption) that own 10% or more of the outstanding voting securities of the fund. In those cases, the SEC counts the owners of the investing companies as owners of the fund when determining eligibility for a §3(c)(1) exemption.

Section 3(c)(7) of the Act provides an exemption for funds owned only by investors with sufficient assets to bear the associated risks of investing.  In particular, this Section provides that issuers are exempt from registration if their outstanding securities are owned exclusively by investors who were Qualified Purchasers at the time they acquired the securities, provided that the issuer was not making and did not propose to make a public offering of the securities at the time of such sales.  For purposes of this Section, Qualified Purchasers are individuals who own at least $5M in investments, or entities with at least $25M in discretionary investments.  Owners who acquire fund securities from Qualified Purchasers through gifts, bequests, divorces, deaths, or other involuntary events, are treated as Qualified Purchasers in determining eligibility for this exemption.

Under the CEA, hedge funds primarily rely on two potential exemptions to avoid registering. The first exempts funds with limited commodity investments, and the second exempts funds that accept only investors deemed able to bear the risk of investing.

Under Section 4.13(a)(3) funds that qualify for an exemption under the 33 Act and are offered and sold without marketing to the public are exempt from registering with the CFTC, provided that: 1) either the aggregate initial margin and premiums required to establish their positions do not exceed 5% percent of the liquidation value of the portfolio, or the aggregate net notional value of positions does not exceed 100 percent of the liquidation value of the portfolio, 2) there is a reasonable belief when investments are accepted that each purchaser is either an Accredited Investor, a Knowledgeable Employee, or a Qualified Eligible Person, and 3) the fund is not marketed as a vehicle for trading in the commodity futures or commodity options markets.

For purposes of this exemption, the Act defines Qualified Eligible Persons as those who are 1) reasonably believed, at the time of purchase, to satisfy the portfolio requirement of owning investments with an aggregate market of at least $2,000,000 and having on deposit at least $200,000 in exchange-specified initial margin and option premiums for commodity interest transactions, or 2) registered as designated industry participants, such as futures commission merchants, broker/dealers, commodity pool operators, commodity trading advisors, investment advisers, or 3) Qualified Purchasers as defined in the 40 Act.

Section 4.13(a)(4) exempts funds that are exempt from registration under the 33 Act that are sold without marketing to the public provided that there is a reasonable belief that every individual investor is a Qualified Eligible Person and every corporate investor is either a Qualified Eligible Person or an Accredited Investor under Reg D at the time the investment is made.

In order to rely upon one of these exemptions from registering as a CPO, funds must file an electronic notice with the National Futures Association prior to delivering subscription agreements to any prospective investors.

Impact on Industry Structure and Practices

The restrictions included in these exemptions explain several long-standing aspects of the hedge fund industry.

The images of secrecy and privilege surrounding this industry primarily reflect a few related factors.  As detailed in several of the exemptions, unregistered funds and advisers are not permitted to hold themselves out to the general public.  As a result, hedge funds rarely have the opportunity to discuss their businesses, industry or results in generally available forums, contributing to the sense of mystery hedge funds hold for the general population.  The need to protect their proprietary investment strategies increases the reluctance of hedge fund managers to publicly discuss their funds or operations, leading to an unusually high level of motivation in complying with these provisions.

Similarly, the restrictions on offering investments to other than permissible investors that are included in the exemptions mean that only affluent, visible individuals are approached to invest, fostering the image of secretive clubs open only to a privileged few.  Following periods of unusually high returns in the industry, this can lead to a clamoring for access by investors not qualifying under the provisions, and for heightened investment by collective vehicles, like pension funds, that represent a broader investor base.

The availability of exemptions from registration and many (but not all) provisions of the federal regulatory framework has also ensured that the barriers to entry into the industry remain low, explaining the rapid growth of the industry and the current large number of small hedge fund managers.  This has been compounded by the availability of prime brokers and administrators to whom internal functions can be outsourced.  As such, the elimination of exemptions or tightening of the requirements for exemptions could cause a shakeout or consolidation among hedge fund managers and an altered industry structure.

Table Summarizing Exemptions from Registration

A pdf version of this table is available here.

©2012 Hedge Fund Regulation. All Rights Reserved.

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The future direction of SEC enforcement was described in broad terms by Robert Khuzami, the new Director of the SEC’s Division of Enforcement, in a speech to the New York City Bar earlier this month.  Khuzami characterized his short tenure at the commission as a time of rapid change, driven in large part by the repercussions and criticisms resulting from the Madoff scandal.  The speech laid out new guiding principles for the Division, including a focus on strategic cases involving major breaches or the potential to deter violations, swift SEC action after a violation, allocation of Division resources to maximize their impact, and increased litigation success based on building stronger cases.

Khuzami announced several specific initiatives related to those principles.

Structural Changes

The proposed changes are responsive to the criticisms raised in the GAO Report on the Enforcement Division, which was delivered this past March and reviewed in a Senate hearing in May.  During the hearing, Richard Hillman, the responsible GAO manager, discussed a number of shortfalls in the Division and a series of recommended changes, which were agreed to by Director Khuzami (who also testified) and are now closely paralleled in the changes he is adopting for the Division.  In particular, the Division will create five specialized units, each having the expertise to enforce a particularly complex area of securities law, with the goal of becoming more efficient and effective in selecting the tips to be investigated and in following up quickly where violations are suspected.  Of particular interest to the hedge fund community, an Asset Management Unit will focus on hedge funds, investment advisors, investment companies, and private equity funds.  Disclosure, valuation, portfolio performance, due diligence and diversification, transactions with affiliates, misappropriation, and conflicts of interest were identified as expected areas of concern.

An Office of Market Intelligence will be created to support the specialized units by collecting, analyzing, risk-weighting, triaging, referring and monitoring progress on tips, complaints and referrals.  The unit will apply internally-developed risk criteria and priorities, possibly reflecting a movement toward a risk-based examination model, as was championed by SEC Chairman Mary Schapiro when she led the NASD/FINRA.

Branch chiefs will be redeployed to conduct investigations in order to increase investigative resources and eliminate duplicative efforts, unnecessary internal reviews and delays in decision-making.

Given the resources being added to investigations and the increase in the Division’s willingness to go to trial, plans call for adding staff to the Trial Unit.  The Division also plans to hire a Chief Operating Officer to manage IT, internal projects, and workflow improvements, along with added support and technical personnel to free up the front-line lawyers who are now responsible and provide them with additional tools for doing their jobs.

Realigned Decision-Making

The Director struck a tough note on enforcement while discussing shits in decision-making authority for a variety of actions.  The net effect appears to be to push authority to proceed lower into the organization while restricting decisions that could slow the progress of investigations.

First, the Commission approved delegation of authority to issue formal orders of investigation, including subpoena power, to Mr Khuzami, who in turn will delegate the authority to senior officers throughout the Division. As a result, when investigatees decline to produce documents or witnesses voluntarily, or are seen as dilatory in their production, investigators will be able to put a “subpoena on [their] desk the next morning.”

Second, a range of senior officers will be given power to approve routine case decisions, a power previously held by the Deputy Director.  Conversely, the Director’s approval will be required for all tolling agreements, which he sees as having become too common.  Memoranda to the Commission recommending enforcement actions will be shorter, subject to fewer reviews, and require quicker turn-around.

Third, the Division is pursuing four initiatives to incentivize cooperation by individuals, including adoption of Seaboard-like standards for evaluating individual cooperation, creation of expedited procedures for submitting immunity requests to the DOJ, providing early oral assurances to witnesses where there is no intent to charge them, and the use deferred prosecution agreements.  These tools will only be used to reward extraordinary cooperation, not routine or expected actions.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Earlier this week, the FSA provided a solid example of rules that address risks created by poorly structured remuneration programs. The FSA rules demonstrate an alternative to pending US legislation and highlight the importance of acting quickly to control 2010 compensation. Under the rules, firms are required to adopt remuneration policies reflecting an included list of principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st. The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

The FSA focused on risks from badly structured compensation agreements, specifically not attempting to address perceived compensation excesses (which are in any case less prevalent than in the US):

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

The code specifies that compensation programs should be based on risk-adjusted long-term profits not revenues, reflect adherence to risk and compliance policies, individual, division, business unit, and firm performance, and Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year. It also calls for limiting guaranteed bonuses to the first year of employment, and spreading payment of at least two-thirds of any senior employee bonuses over a three-year period.

Firms with inconsistent contract obligations are called upon to amend such obligations within set time frames.

Our detailed analysis of the FSA rules and a comparison with USA proposals are available here.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Summary: Detailed analysis of new FSA rules designed to prevent UK financial services firms from adopting remuneration programs that could encourage key staff to take excessive risks; includes a comparison to US proposals. A briefer entry is available here.

Earlier this week, the FSA provided a workable example of rules that address the risks that can result from poorly structured remuneration programs at financial firms.  Given the uncertain and politically charged debate now underway in the US, this example deserves our attention.  The new FSA rules also highlight the importance of acting quickly enough to affect the upcoming 2010 compensation year – something that will be difficult here where pending legislation provides regulators with a nine-month period to in effect assess the need for action.

By already putting its requirements into effect, the FSA pulled ahead of its counterparts in the US.  The changes go into practice quickly to address the 2010 compensation cycle: firms must adopt remuneration policy statements reflecting the new principles, have them approved by board compensation committees, file them with the FSA by the end of October, and put them into practice by January 1st.  The rules also provide guidance on addressing pre-existing contracts like the questions being raised concerning Andrew Hall’s employment agreement with Citibank.

To act quickly, the FSA focused specifically on the risks created by badly structured compensation agreements, rather than getting caught up in a debate about popular outrage over perceived excesses as has happened in US.  In balancing its reform efforts, the FSA noted that “inappropriate remuneration policies, practices and procedures were a contributory factor rather than a dominant factor behind the market crisis.”  As such, the UK code provides an interesting example of regulations more in tune with traditional financial regulation – mandating formal policies and procedures, internal oversight roles, and specific practices – than the US approach, summarized in another posting on this site, which attempts to limit risk by ceding more compensation authority to shareholders and regulators.

In its newsletter, the FSA describes the intent of the code as getting boards and firms to adopt compensation incentives that more strongly promote good risk management practices:

The aim of the Remuneration Code is to ensure that firms have risk focused remuneration policies, which are consistent with and promote effective risk management and do not expose them to excessive risk.

In keeping with the results focus at the heart of policy-based regulation, the provision anticipates efforts to engineer around any rules-based limits, extending coverage to “all aspects of remuneration that could have a bearing on effective risk management including wages, bonus, long term-incentive plans, options, hiring bonuses, severance packages and pension arrangements.”

Content of the FSA Rules

Structurally, the code modifies existing provisions to require firms to have board-level compensation committees and adopt written compensation policies and procedures.  The procedures must include performance appraisal processes and must allow for the risk and compliance areas to have “significant input” if they are concerned that a decision could encourage risky behavior or include a potential conflict of interest.  The code also extends the definition of regulated business risk to include risks arising from remuneration policies.

The code amends the Senior Management Arrangements, Systems and Controls Sourcebook to include a series of new principles to be applied when setting remuneration for individuals who could significantly impact the performance or risk exposure of the firm.  Under these principles, their compensation should:

• Be based on risk-adjusted profits not revenues
• Reflect long term profits, potentially through the use of moving averages, deferred payouts, or risk adjustments
• Be significantly affected by an individual’s non-financial performance, including adherence with the firm’s risk and compliance policies
• Tie bonus levels to individual, division, business unit, and firm performance (their emphasis)
• Include vesting periods and dependencies on future firm performance for deferred bonuses
• Include a base component sufficient to allow the firm to choose not to pay a bonus in a given year
• Be set using appropriate, accurate management reports for the relevant areas of the business

Beyond these principles, the code calls for two specific compensation practices: first, guaranteed bonuses should be limited to the first year of employment, and second, payment of at least two-thirds of any senior employee bonuses should be spread over a three-year period.  Special considerations also apply to determining compensation of risk and compliance staff whose compensation is expected to be adequate to attract the required talent but “significantly” less variable or performance based than other positions.

Firms unable to comply with the new provisions because of existing obligations will not be considered in violation provided they amend such obligations to be compliant at the earliest opportunity prior to the end of March 2010.  Firms unable to do so by that date must take reasonable steps to amend or terminate the obligations at the earliest opportunity (and in no case later than the end of December 2010) and must adopt specific, effective procedures to manage any risks raised by such obligations while they remain in effect.

Comparison with Proposed US Regulations

In contrast to the FSA rules, the pending legislation in the US relies on added control from shareholders, through non-binding say-on-pay votes, and from regulators through oversight to moderate the risk created by poorly designed compensation programs.  In the author’s opinion, these mechanisms will prove to be significantly less effective than the FSA framework.

One of the persistent criticisms of shareholders in the our markets has been their focus on quarterly (or shorter-term) performance.  The now out-of-favor growth in options-based compensation, which increased the risk appetite of many senior executives, was instigated to make management more responsive to such shareholders who supported management during the upside of the bubble. As noted in the clip at left of John Coates – a professor of law and economics at Harvard – testifying before a Senate hearing on Improving Corporate Governance, shareholders of financial service firms with implicit and explicit guarantees are likely to have a larger risk appetite than we would have as citizens providing those guarantees.  Moreover, shareholder democracy will mix a wide variety of other factors into these votes and be restricted to a binary (and non-binding) yes or no vote.  While say-on-pay may be effective in allowing corporate critics to attack compensation packages that are “too large,” it is far less likely to provide the information or opportunity for the analysis needed to establish a societally-appropriate risk appetite and determine whether compensation is aligned with that appetite.

On the other hand, regulators will have more flexibility to evaluate the impact of proposed compensation structures as a part of their prudential supervision.  Given the wide scope allowed for prudential supervision, this of course was already within their purview for federally regulated banks while the current crisis was brewing.  In the case of the largest banks, which contributed disproportionately to the crisis, the FRB provided continuous, engaged risk oversight under the Large and Complex Banking Organization program.  This did little to reduce the exposure: unlike a determination that an individual’s compensation is simply sizable, close engagement with the content and practice of the business is required to determine whether it creates undue risk, and regulators generally do not have that level of engagement.

In contrast, the FSA framework closely parallels the reliance placed on internal compliance and risk professionals in the Institution-Based Regulatory approach that is widely applied to the US securities industry (and recently proposed for the credit rating agencies).  By creating explicit policies and procedures for establishing executive compensation, and placing dedicated risk and compliance professionals in a position to apply those procedures to review and approve potentially risky compensation packages, that framework applies a model that has generally worked well in the US.  Moreover, by leveraging the CCOs and procedures already in place, it can be applied more rapidly while leaving regulators the opportunity to review their findings and verify that the framework is being appropriately applied, tasks at which they have proved to be effective.

©2012 Hedge Fund Regulation. All Rights Reserved.

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This week both the SEC and the FSA disclosed steps that could lead to restricting certain practices related to high-frequency trading. According to Bloomberg News, the FSA is meeting with market participants including hedge funds, banks, investment banks, and investment managers to assess the overall impact of high-speed trading in the UK.  Yesterday, Senator Schumer announced that Mary Schapiro at the SEC had promised to attempt to enact a U.S. ban on flash orders, one type of high-speed trading in which major firms have a fraction of a second to react while orders are passing through “dark pools” prior to being routed to open public markets.  That promise builds upon a speech in June, in which she pointed to a potential “danger that significant private markets may develop that exclude public investors” when announcing that the Commission was considering restrictions on high-speed trading.

The timing of the SEC investigation is in part a response to a letter to Chairman Schapiro from Senator Schumer condemning the practice as unfair, a part of which is included below.

Flash orders allow certain members of these exchanges to obtain access to order flow information before that information is made available to the public, allowing those members to use rapid trading programs to trade ahead of those orders and profit from advanced knowledge of buying and selling activity. While pre-routing programs can benefit markets by providing additional liquidity, this kind of unfair access seriously compromises the integrity of our markets and creates a two-tiered system where a privileged group of insiders receives preferential treatment, depriving others of a fair price for their transactions.

Besides any direct impact of potential regulations, the tenor of the discussion contains a significant message. The statements to date emphasize the priority that will be given to achieving fairness in the markets, including the relative weighting given to individual-level fairness over market efficiency in Senator Schumer’s letter.  A similar view was expressed in an opinion by economist Paul Krugman in Monday’s New York Times, in which he questions how “traders who place their orders one-thirtieth of a second faster than anyone else do anything to improve” the markets.

Although articles, including Paul Krugman’s op-ed piece, have focused on Goldman Sachs, NPR reported that the firm has sent a letter to its clients in which it denies engaging in-flash trading or any other programs where information from client orders is used before trades are completed, and revealed that all forms of high-speed trading together were responsible for only about 1% of 2009 revenues.

As reflected in that letter, it is important to bear in mind there are multiple types of high-speed trading; besides the specific mechanism described above for flash-trading, other programs simply rely on reacting to pricing more quickly to take advantage of market conditions.  To put this into context, the Tabb Group published a study last year entitled “The Value of a Millisecond” (link to the catalog entry, not the $3,000 study) in which they concluded that an electronic brokerage firm would lose 10% of its revenues for each 10 millisecond increase in transaction latency.

We believe that one of the key longer-term lessons in all of this comes from the Goldman quote in the NPR article stating that “the most significant challenge ahead is for the regulatory framework to keep current with the rapid pace of innovation in the marketplace.”  It will be important for regulators to keep this in mind as they craft regulations to deal with the perceived issues arising from today’s technology.

©2012 Hedge Fund Regulation. All Rights Reserved.

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The Washington Post reported today that on at least two occasions the SEC has been forced to grapple with conflicts between their enforcement role and the role of the U.S. government as a significant investor in (Regions Financial) or influencer of (Bank of America) a large financial services firm.  In both cases, the SEC chose to pursue an enforcement action, but additional conflicts are likely to surface in the future since the government has acquired interests in a number of banks and other financial institutions through the TARP program.   Nevertheless, the Post quotes Robert Khuzami, who directs the SEC’s Enforcement Division, as saying that he expects few actual conflicts to arise.   And, for the larger, systemically-important institutions such conflicts may not alter the balancing act underlying their decision to proceed with enforcement: the article points to an example last year where the regulator felt the need to pause to consider a similar concern concerning potential damage to the system if a settlement pushed one or more of the large institutions involved over the edge.

©2012 Hedge Fund Regulation. All Rights Reserved.

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The Wall Street Journal reported today, and Reuters confirmed, that Secretary Geither called in the heads of the FRB, the SEC, the CFTC and the FDIC (among others) on Friday to lay down the law in no uncertain terms on their mandated public support for the Obama Administration’s reform plans and to demand they stop the “sniping” that has been going in turf wars among the agencies.

In the video clip above (which will include a brief commercial from the Journal), the WSJ’s reporter Deborah Solomon cites growing unease at senior levels with the slow pace in Congress, the pushback from the industry as well as the divisions among the ranks of regulators as sources of the high level of frustration that led to the reportedly tough, expletive-filled meeting atmosphere.

Despite the strong language in the meeting last Friday, at least some of the regulators remain quite independent as far as expressing their views.   In particular, the heads of the OCC and the OTS, which would be consolidated under the Administration’s current proposal, voiced their disagreement. In his testimony before the Senate Banking Committee on August 4th (shown in the clip at right), John Dugan, the Comptroller of the Currency, voices support for many elements of the Administration’s proposals but disagrees forcefully with some key elements, including proposals to give the FRB authority to override his agency’s standards and enforcement in some circumstances, and to consolidate enforcement of consumer provisions in the proposed CFPA, thereby divorcing consumer and prudential regulation.  John Bowman, acting head of the OTS, disagreed with the premises for consolidating his organization noting that the actual distribution of failures did not support the regulator-shopping accusations on which the proposal was based.

In response to a question from Senator Shelby citing the WSJ article, each regulator specifically stated that they all were giving their own, independent views, as is required by the terms of their charters.

Nevertheless, in an interview with the Wall Street Journal on August 13th, Secretary Geithner remained confident that the Administrations program was on track.  As the Journal summarized the situation:

The administration’s plan has lost some momentum since it was unveiled in June, with lawmakers postponing votes on key portions of the proposal, the industry criticizing much of it and regulators battling over turf. But Mr. Geithner said the effort is “doing fine” and predicted the administration will get most of what it is seeking when Congress returns in September.

One certainly would expect the meetings at Treasury to remain interesting at least until the disposition of the proposed legislation becomes clearer.

©2012 Hedge Fund Regulation. All Rights Reserved.

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On July 27th, the Investor Advisory Committee conducted its kickoff meeting led by its Chairman, Luis Aguilar (an SEC Commissioner).  The Committee, which was announced by the SEC  in June, is chartered “to provide the Commission with the views of a broad spectrum of investors on their priorities,” which the SEC will consider when assessing potential regulatory reforms.

The kickoff deck from the meeting, a press release, and a video archive link are available on the committee’s website. Among the topics the deck lists as being of interest to the Committee are the following:

• Fiduciary duties
• Disclosure
• Investor-director communications
• Treatment of credit based instruments (like derivatives)
• Arbitration
• Valuation
• Majority voting
• Proxy voting
• Corporate governance

Although the topics actually discussed last week were more relevant to retail investors, the topics listed and Committee makeup indicate that future discussions are likely to be of interest to hedge funds.

©2012 Hedge Fund Regulation. All Rights Reserved.

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In his opening statement on July 24th before the House Committee on Financial Services, Secretary Geithner discussed the Administration objectives and priorities underlying the Financial Regulatory Agency Restructuring plan.  In the oral statement, a clip of which is shown at left, the Secretary emphasized the need for the two new agencies being proposed in the plan: the Consumer Financial Protection Agency and the Financial Services Oversight Council. The CFPA was designed to better target abuses by imposing uniform standards across all institutions and by having authority over sectors the Administration sees as having been under/unregulated.  The FS Oversight Council is to promote financial stability by addressing risk taking practices, including the use of leverage seen as excessive, that are thought to have contributed to the current crisis by (1) addressing a broader range of institutions, (2) working toward international cooperation and enforcement, and (3) having stability as its primary goal, which is not true of other regulators according to the Secretary’s statement.

The full text of the statement, which includes other topics, is available here.

©2012 Hedge Fund Regulation. All Rights Reserved.

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On July 21st Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies by amending Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include greatly increased risk and reliability related disclosures in their ratings reports, and (5) file annual regulatory reports, including compliance certifications.  Among other topics, the mandated policies and procedures must address conflicts of interest in the rating process.

The proposal directs the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business pricing and business practices. This would amend the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration.

Our detailed analysis of the proposal is available here.

©2012 Hedge Fund Regulation. All Rights Reserved.

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A recent WSJ article reported that hedge funds are experiencing their best performance in a decade due, at least in part, to declining competition for market opportunities from proprietary trading by the major banks which have become more conservative.  This provides an explanation for a Morningstar report on July 21st that during the second quarter their index of 1,000 hedge funds had posted its best quarterly return at 9.25% since the inception of the index in 2003.  The prior best was just 7.40% in 2003.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Yesterday the House voted to amend the 34 Act to give regulators the power to veto incentive-based pay packages at institutions with over $1B in assets when they find that the packages would induce excessive risk-taking.  The bill also mandates that shareholders of a registered company be given the opportunity to cast advisory votes on the company’s compensation practices.

In most cases, reform efforts have focused on giving more power over executive compensation to shareholders, but this legislation goes further, imposing limits overseen by regulators.  In an editorial in the Financial Times, Professor Bebchuk of Harvard Law School supports the proposal on the grounds that these shareholders benefit from explicit and implicit government guarantees, creating a moral hazard that they will be comfortable with more risk than is justified economically and therefore approve incentives that reward excessive risk taing.

A widget from OpenCongress that will track the progress of this bill is included at left.  Added information about the bill and links to sign up for alerts and other services for this or other bills are available on their site.

Following are the links to:

• Full text of House Bill 3269
• An article from the New York Times
• An article from Reuters
• Comments by Secretary Geithner

©2012 Hedge Fund Regulation. All Rights Reserved.

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Summary: Detailed analysis of the Treasury’s proposal to require Credit Rating Agencies to register with the SEC and implement enhanced compliance organizations, practices and disclosures.  Includes analysis of the actions the SEC is directed to take to implement the proposal.  A briefer entry is available here.

Last week the Department of the Treasury proposed legislation to strengthen regulatory oversight of national credit rating agencies, one of the groups that has been pointed to as contributing to the current financial crisis. The proposal would amend Section 15E of the 34 Act to require agencies to (1) register with the SEC as “nationally recognized statistical rating organizations” (NRSROs), (2) create internal compliance organizations under a CCO, (3) implement written policies, procedures and codes of ethics, (4) include increased risk-related disclosures in ratings reports, and (5) file annual regulatory reports, including compliance certifications.  The proposal also requires the SEC to create an office dedicated to overseeing NRSROs and to adopt rules to change industry business practices thought to compromise the efficacy of the rating practice, as well as to detail the rules required to implement the Act.

This legislation builds upon the Credit Rating Agency Reform Act of 2006 and its associated regulations, which provided for optional registration and were themselves extensions of earlier Commission efforts to increase the reliability of the ratings process through a series of no action letters.  The approach taken in the proposal to improve the conduct of the NRSROs mirrors regulatory provisions adopted over the past several years to tighten the governance and compliance environments in regulated broker/dealers, investment advisers and investment companies, including the development of written policies and procedures, the adoption of codes of ethics, the designation of Chief Compliance Officers, and the institution of systems of internal controls.  The specific concerns targeted in the proposal also reflect the increased focus that governance experts, like Professor Coffee at Columbia, have placed on dealing with conflicts of interest between the “gatekeepers” like the auditors and rating agencies and their clients, as the basis for structuring statutory and regulatory requirements.

On August 5th Professor Coffee testified before the Senate Committee on Banking, Housing and Urban Affairs concerning this proposal. In his opening statement, a clip from which is included at left, Professor Coffee points to two shortfalls in the Treasury proposal relative to legislation proposed in April by Senator Reed, which he believes would make the measure ineffective in remedying the problems it targets. First, the proposal fails to address the lack of due diligence reviews by the agencies of the inputs used in their models. Second, rating agencies don’t face the same risks of potential legal liability that motivates most other gatekeepers to adopt rigorous measures to verify the accuracy of their work products.

Concern with the reliability of credit ratings has been voiced by a number of firms and organizations in the investment industry, especially by those managing money market funds which are required to apply NRSRO ratings when selecting certain investments.  In April representatives from some of the leading investment firms, the industry groups, the NRSROs, and academia participated in an SEC roundtable on this issue.  While much of the discussion called either for a more dramatic restructuring of the industry at one extreme, or for much less change than the proposal includes at the other, depending mostly on the affiliation of the participant, there was clear agreement that change is required because the markets have lost confidence in the ratings being issued.  In his statement, Richard Baker (the President and CEO of the Managed Funds Association) noted the concerns of the alternative investment industry, described the agencies as playing a fiduciary role,  and called for regulators to require increased disclosure, greater transparency, and some form of accountability.

NRSRO Requirements

The Act directs the SEC to promulgate rules specifying how NRSROs are to manage conflicts that arise from business relationships, affiliations or board overlaps with the issuers they rate, from any affiliations among their staff and the issuers or underwriters of rated securities, and from any any other sources of conflict they identify.  Based on these rules, each NRSRO will be required to establish and enforce compliant written policies and procedures, reasonably tailored to their activities to identify, address and disclose conflicts of interest involving the agency or its staff, and to strengthen their governance procedures for managing such conflicts as may arise.

In line with recent critical commentary from investors, the Act attempts to deal with the inherent conflict created because issuers pay for their ratings.  The Act specifically directs the Commission to promulgate rules specifying how NRSROs are to deal with conflicts related to the compensation model.  It also calls upon the SEC to devise changes in the industry’s payment and incentive practices to ensure that NRSROs maintain accurate and reliable ratings following an issuance, and it provides for censures and penalties if they do not.

To protect the independence of the rating process, the Act prohibits NRSROs and their affiliates from performing rating services for an issuer for whom they have performed other services, such as risk management advisory or consulting services, in return for for separate compensation.

Again addressing potential conflicts, if an employee leaves an NRSRO and and takes a position with the underwriter or issuer of a security they helped to rate during the preceding year, the NRSRO is required to perform a look-back review and, if necessary revise, the rating on such security.

The legislation’s approach to achieving NRSRO compliance builds on the current regulatory philosophy of fostering a strong corporate compliance environment to internalize oversight.  In a formulation reminiscent of the 38a-1, 206(4)-7 and 3010/3012/3013 requirements applicable to investment companies, advisers and broker/dealers, respectively, the SEC is directed to verify that the NRSRO ”established and documented a system of internal controls, due diligence and implementation of methodologies” and is in fact adhering to the system.

We’ve characterized this model as being an outsourcing of portions of the regulatory oversight function from the SEC to the regulated firms, but in a 2008 issue of the Harvard International Law Journal John Walsh (Chief Counsel of the OCIE at the SEC) used the better term Institution-Based Regulation. By showing how thoroughly the regulatory community has accepted this model, this proposal emphasizes the intent of the SEC to push for the imposition of the Institution-Based model in other sectors of financial services, as it would be enabled to do with hedge funds if the Private Fund Investment Advisers Act is passed.  It also presages how forcefully the SEC would apply the model afterward.

Again in parallel with the earlier regulations that applied the model, each NRSRO will be required to designate a Chief Compliance Officer (CCO) to administer the required compliance framework, overseeing compliance with (1) the policies and procedures that deal with conflicts, (2) the procedures, methodologies, models and controls that apply to the rating processes, and (3) all applicable securities laws.  The Act requires applying a risk-based approach in which the CCO’s selection and depth of review takes into account the risk that potential non-compliance in an activity could compromise the integrity of the ratings assigned. To help identify potential compliance issues, the CCO will be responsible for establishing and overseeing procedures to collect and deal with customer and confidential employee complaints, and for overseeing efforts to remediate any compliance issues that are identified.

CCOs will be required to prepare and certify annual reports on compliance by their NRSRO, which will be included with the firm’s financial filings with the SEC.

The CCO must be a direct report to the board of the NRSRO and cannot participate in the rating process, the development of ratings models, marketing or sales activities, or in setting compensation for non-compliance staff.

Directives to the SEC

Under the proposed legislation, the SEC will be charged with prescribing rules requiring the board or senior officer to approve the procedures, methodologies, and models used to perform their ratings, requiring that procedures are in place to ensure any changes in the models or procedures are applied uniformly, and that the users of ratings are notified which versions were used to arrive at a given rating and when changes were made in the models or procedures.  The rules will also require NRSROs to develop distinct rating symbols for structured v. non-structured securities within two years.  The SEC is to develop disclosure forms required to accompany each rating, which are to include information about the methodologies used to produce the rating, any known potential shortcomings in the rating process used, background on the level of certainty of the rating, the nature and relative quality of the data used to arrive at the rating, and any external due diligence reviews performed.  Agencies will be specifically required to discuss the potential volatility expected in the rating along with their estimates of the probabilities of loss or default.  These extensions of NRSRO disclosure requirements build on the enhanced disclosure required under the rules adopted by the SEC last December.

The Act directs the SEC to conduct reviews no less than annually to verify that each NRSRO has established and documented the required system of internal controls, due diligence, ratings methodologies, and look-back procedures, that it operates in conformance with its documented procedures, and that its public disclosures are consistent with them.  The scope of the review is to include every type of credit rating the NRSRO performs and the Commission’s report is to be made public along with the NRSRO’s code of ethics and conflict of interest policy.  If it so elects, the Commission is given the authority to delegate these reviews to the PCAOB.

Finally, the SEC is directed to create and staff a new office chartered with administering the regulation of NRSROs, and to develop the detailed rules, forms, and standards needed to implement and enforce this Act.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Summary: Analyzes the Administration’s proposal to require registration with the SEC, added record-keeping, and filing of annual reports concerning investment practices and clients; includes an analysis of the potential impact of giving the SEC broad power to define terms (including ‘client’) in the Act. A briefer entry is available here.

On Wednesday July 15, the Administration released its widely-expected proposal to require most hedge fund advisers, and most other managers of pools of private equity, to register under the Advisers Act.

The proposal would immediately eliminate the exemption from Advisers Act registration for most hedge fund advisers to the extent of requiring them to register for purposes of imposing record keeping and reporting requirements.   A second consequence of the proposal, which is likely to have the larger long-term impact, is to clarify the power of the SEC to interpret the terms of the Advisers Act, including the term ‘client’, in effect granting the Commission the power to broadly eliminate the Advisers Act exemption, a power which the court found lacking in Goldstein vs. S.E.C..

Immediate Impact

The stated intent of the proposal is to require such record-keeping and reporting as the SEC deems necessary or appropriate: (1) in the general public interest, (2) for the protection of investors, or (3) for assessment of systemic risk.

Like the Commission’s overturned 2004 regulations that required hedge fund advisers to register, the proposed statutory language addresses advisers to ‘private funds’, where a private fund is defined as an investment fund that would be subject to the 40 Act but for the provisions of 3(c)(1) or 3(c)(7), which of course are the provisions relied on by funds exempt from registration under that Act.

Under the proposal, the SEC is authorized to require advisers to private funds to keep records of AUM, use of leverage, counterparty credit exposure, trading and investment positions, and trading practices – along with any other information the Commission determines to be necessary.  The Commission is given the power to determine the mandated record retention period and examination protocols.

By including position, trading and trade practice data, the reporting requirement will encompass much of the the core strategic information now closely held by the advisers.  The SEC is directed to treat the collected information as confidential, subject to the requirement to make it available to the FRB as required to identify those advisers which could pose a systemic risk (who would be designated Tier 1 FHCs).  The Commission also is required to provide confidential treatment to such information to the extent that it is included in its findings and reports, provided that it must disclose such information to the FRB and to such other government agencies and SROs as may require the information.

The proposal would also require advisers to provide added information to investors, prospects, counter parties and creditors in the form of such reports and information as the Commission may prescribe.

Finally, the amendment would explicitly strike the Section 210(c) provision of the Act that limited the Commission’s ability to require an adviser “to disclose the identity, investments, or affairs of any client.”  This again opens their access to strategically sensitive information.

Longer-Term Impact

The proposal goes on to ‘clarify’ the rulemaking authority of the SEC.  In particular, the Commission is authorized to interpret the definition of all terms in the Advisers Act, specifically including the term ‘client.’  When the SEC last tried to require registration of hedge funds in 2004, they did so by reinterpreting ‘client’ to mean investors in the fund, not the hedge fund itself, meaning that virtually all hedge fund advisers would exceed the 15-investor limit on the 203(b)(3) exception to registration.  In Goldstein vs. SEC, however, the Court found that the Commission lacked the clear authority to change this interpretation and, on that basis, invalidated the requirement.

Based on this history, the impact of this portion of the proposal would be to allow the SEC to once again require hedge funds to register under the Advisers Act, effectively nullifying the basis for the the Court’s finding in Goldstein (as you’d expect given the use of the term ‘clarify’ in the proposal).   This clears the way for the SEC to reintroduce the hedge fund registration requirements it adopted in 2004.  As with that earlier attempt to regulate these advisers, by dropping their exemption the Commission would impose all of the requirements of the Advisers Act upon them, including potential limitations on compensation and the administratively complex requirement to adopt extensive policies and procedures detailing their internal controls.  Beyond this, the Commission will also have the opportunity to impose new requirements if deemed appropriate.

The proposal also makes it clear that the Commission has the authority to vary requirements under the Act for different classes of person or different situations, opening the possibility of tiered regulations based on adviser size, client base or strategy.  Thus, as we’d speculated in an earlier posting ( The Impact of Registration ), it appears that the real impact of the Administration’s proposals will be determined by the detailed requirements developed in part by the Congress, but more likely by the SEC following the adoption of amendments to the Advisers Act.

©2012 Hedge Fund Regulation. All Rights Reserved.

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On July 15 the Administration released proposed legislation that would require most hedge fund advisers and other managers of pools of private equity to register with the SEC for purposes of imposing new record keeping and reporting requirements tailored to the private funds.  Confidentiality of the filings is addressed in the proposal, but requirements for sharing with other agencies are included. The proposal also clarifies and extends the power of the SEC to interpret the terms of the Advisers Act, including the term ‘client’, which would effectively overrule Goldstein vs. S.E.C. and thereby give the Commission the power to fully eliminate the Advisers Act relied on by most unregistered hedge funds, as it tried to do in 2004.

Our detailed analysis of the proposal is available here.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Summary: Based on statements by the Administration and the SEC, analyzes potential consequences of requiring hedge funds and other managers of private funds to register with the SEC.  The analysis notes that proposal largely defers the details so that the impact will depend on the interpretations and enforcement that the SEC adopts after the legislation is passed.

Given the administration’s proposed foundation for Financial Regulatory Reform, the presence of multiple bills in Congress, and the vocal acquiescence of the hedge fund industry itself, it appears certain that most hedge fund advisers will be required to register under the Advisers Act by year-end.  The prospects are sketchier, but comments from Mary Schapiro at the SEC and some of the legislative momentum indicate that the funds themselves may be required to register under the 40 Act.  Hedge Fund registration of either sort obviously isn’t an end in itself, however – the response of the industry and any cost/benefit assessments will depend on what is to follow registration.

For example, registration could be a precursor to having the regulators / SROs increase their oversight of individual hedge fund activity.  For the more visible recent problems like Madoff and Stanford Financial, however, the primary problem seems to have been gaps in the effectiveness of the oversight performed in its ability to achieve the twin goals of protecting investors from abuses and protecting the system from catastrophic risks.

The secondary problem has been the high compliance cost imposed on registered entities to achieve these limited benefits, as documented in SIFMA’s study of the Costs of Compliance in the securities industry. The recent scandals clearly undercut many assumptions underlying the asserted value of the hedge fund regulation already in place.

Given access and repeated guidance, regulators who arguably focused more on monitoring technical compliance than detecting intentional fraud were unable to find the what should have been obvious problems at Madoff.  Many of the sophisticated accredited investors, institutions and even funds-of-funds who are presumably able to look out for themselves also were unable to spot, or simply overlooked, the red flags at Madoff’s firm (though the smart money appears to have known there was a problem).

The resulting impact on investors demonstrates the need to do better on the first goal of regulation – to protect investors.  Unfortunate stories from many of Madoff’s victims undercut the idea that we can safely rely on “accredited” investors to have the requisite sophistication to deal with a fund just because they have sufficient assets.

Conversely, in all of the recent references to hedge funds, it’s hard to find an issue with the second goal – to protect against a material systemic impact during a downturn that results from the conduct of individual funds.

It could be argued that the pattern of fund transactions to implement certain strategies increased the pressure on some stocks, industries or the market in general at inopportune times, but this type of systemic exposure across firms (as with CDSs during the present crisis or historically with portfolio insurance in 1987) is not something highlighted in the Administration’s document or Congressional proposals.  Instead, their focus is on identifying firms whose individual conduct or failure has the potential to materially harm the system.  To obtain the ability to identify hedge funds in this category is one key reason given for requiring registration and filings by hedge funds.

Thus, the utility of any new filing requirement remains to be demonstrated as the Congress, Administration and the regulators specify what consequences will follow from the all-but inevitable requirement to register, and what added capabilities will be developed by the regulators to productively use their added leverage.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Over time I’ve found there’s a lot to be learned by exploring those questions that seem simple but require complicated answers, and defining a “hedge fund” falls squarely in that category. Therefore, I hope you’ll bear with me for an overly long post exploring this particular question.

Beyond the simplistic, and not entirely accurate, explanation that the name reflects the fact that hedge fund advisers use hedging to increase returns and decrease volatility, an analysis of the definition of a hedge fund can provide insights into what is really distinctive about these advisers both individually and as an industry. I believe this effort is timely because these distinctions will play a major role in determining the real impact (intended or otherwise) of the upcoming regulatory changes.

According to some histories, the term “hedge fund” was originally applied to A.W. Jones & Co, a general partnership started by Alfred Winslow Jones in 1949 and subsequently changed to a limited partnership in 1952 (others, including Warren Buffett, point to earlier investors like Benjamin Graham). The term fit well because Jones’ fund was distinctive in that besides buying securities viewed as under-valued, he hedged by short-selling securities believed to be over-valued. Because the short positions provided some protection against a drop in the market, he felt safe in borrowing to increase the leverage of the fund – without hedging “I would not have been able to sleep so well at night.”

Articles about Jones in Fortune, Institutional Investor, and New York Magazine during the 1960’s provided some early insights into the hedge fund industry, highlighting a number of hedge fund characteristics that remain typical of the industry today:

• Shorted securities seen as over-valued to hedge market risk and benefit from relative underperformance
• Used leverage (about 50% at A.W. Jones at that time) to increase returns
• Insiders contributed a significant portion (40% originally) of hedge fund assets
• Restrictions applied to fund additions and withdrawals (annual only)
• Funds had high trading volumes
• Managers received a 20% performance fee
• Funds operated under a limited partnership legal structure
• Funds and advisers were exempt from Adviser Act and 40 Act registration
• Advisers limited disclosure of business and client information
• There was a tendency for staff to leave to form competing hedge funds after learning the ropes

And, again showing the breadth of continuity, the New York Magazine article noted a couple of the industry’s concerns in 1968 with potential regulatory changes that are at least as timely today:

• Being subjected to registration with the SEC and increased regulation
• Losing the carried interest treatment of performance fees

Much, however, has changed in the hedge fund industry during the past forty years.

Most striking perhaps is the growth of the industry, going from an estimated 100 hedge funds in 1968 to between 6,000 and 8,000 today, and from about $2 billion in assets in 1968 to a peak of more than $2.8 trillion in 2008.

The 1966 Fortune article was viewed as an early catalyst for starting this rapid growth in hedge funds during the late 1960s because it publicly exposed their little-known structures, methods and returns. Because hedge funds are less regulated than banks, brokers or other financial firms, the barriers to entry have always been low – explaining the large number of new and relatively small firms. The emergence of prime brokers and administrators made it even easier to form, grow and finance a hedge fund advisory firm.

While funds continue to “attract some of the best investment talent with extraordinarily high rewards,” as New York Magazine put it in 1968, the size of those rewards also has grown beyond recognition. Where the Magazine positively gushed about managers being able to earn a few million dollars at that time, in 2008 (not a great year in the market) eleven managers earned over $250 million and four earned over $1 billion. But that level of compensation does have the benefit of continuing to attract and motivate some of the strongest investment talent (as well as a few rogues).

Over the years, that talent has been applied to broaden several distinctive characteristics of the original hedge funds almost beyond recognition. Jones recognized and exploited one market inefficiency in the underutilization of short sales and particularly in the role they could play in reducing portfolio volatility. Since then, hedge fund managers have continued to look for other inefficiencies on which to base new strategies. Beyond the long-short equity hedge strategy used by Jones, Hedge Fund Research now catalogs over fifty distinct categories of investment strategies, each of which includes multiple variations. In effect, each hedge fund manager uses his or her experience and expertise (with varying degrees of success) to identify non-traditional or underutilized investment opportunities across all markets and countries to earn atypical returns.  In this sense, the role of a hedge fund is to discover opportunities to generate excess returns, known as Alpha in the industry, for the level of risk incurred.  In fact, the term Alpha Hunter is one slightly tongue-in-cheek definition that has been given for a hedge fund (in contrast to the run-of-the-mill beta-grazers at other advisers).

But, in broadening their investment strategies, some managers arguably have lost the hedging effect that Jones intended for his portfolios. In some cases, the exposure has been intentional – the manager wanted to place a bet; in others the hedge simply relied on relationships among securities that were too remote or subject to too many other influences.

In a 1998 article in his Interest Rate Observer contemplating the impact of Long Term Capital’s failure, Jim Grant noted that Jones actually referred to his fund as a “hedged” fund not a hedge fund, emphasizing that Jones’ intent was to reduce risk (seeing short sales as “a speculative tool used to conservative ends”) whereas hedge funds at that time (LTCM in particular, but many others to a lesser degree) were instead using short sales and leverage to place outsized bets. As a result of the high levels of leverage used by LTCM (around 100 times equity), the systemic risk anticipated from its failure prompted the FRB to help arrange a consortium of private firms to essentially buy out a 90% interest in LTCM to stem the expected impact that could have resulted. This was a difficult decision for the FRB forced by the perilous state of the markets at that time, as discussed in the C-Span video clip on the left from Chairman Greenspan’s later Congressional testimony, and one from which the FRB claimed to learn lessons for dealing with future crises. Given the high levels of leverage reached by hedge funds during 2008 and the current heightened concern with systemic risk, the considerations and reluctance to intervene discussed by the Chairman should be key elements in any discussions of hedge fund regulation, particularly in light of the lack of evidence of systemic risk generated by hedge funds during the current crisis.

Putting all of the above together, the defining characteristics of a hedge fund can be summarized as the pursuit of returns in excess of those normally expected for the level of risk assumed, by advisers who are highly motivated by the opportunity to share in those gains, and who are able to make alternative investment choices, including the use of hedging, that are less constrained by the regulatory limits that apply to non-hedge fund advisers (such as restrictions on shorting, leverage or non-standard investment classes).

To sustain those characteristics, most hedge funds also have worked to retain their exemptions under the Advisers Act and 40 Act, which has meant remaining limited in the number and types of direct investors in each fund and restricting their public visibility; two other characteristics often associated with hedge funds.

Thus, the proposed registration requirements pose a real threat to some of the basic characteristics of the industry. Among other things, losing the Advisers Act exemption could restrict performance-based fees, and losing the 40 Act exemption could restrict the use of leverage and some investment strategies (as well as requiring more disclosures about their proprietary investment strategies). The significant added cost of compliance would increase the minimum economic scale required for an adviser to operate, probably leading to extensive consolidation and/or closings among the smaller advisers.

In addition, the industry faces serious market challenges to their basic business model. The recent wave of highly visible scandals (e.g., Madoff and Stanford Financial) has caused a drop in assets under management, an increase in investor concerns, added scrutiny during due diligence reviews, and a resulting increased investment in risk management and control. The drop in performance of many hedge funds in 2008 also shook investor confidence (and perhaps the over-confidence of some advisers) in an industry that had come to speak in terms of absolute performance. Finally, the sheer proliferation in funds has already arbitraged many of the inefficiencies out of the markets.

These pressures also are likely to cause consolidations and closings.

©2012 Hedge Fund Regulation. All Rights Reserved.

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Welcome, but I’m afraid you’ve arrived while construction is still underway.

I’m in the process of creating this Hedge Fund Regulation blog as a platform for tracking, discussing and helping practitioners to cope with the increased level of regulation that we all know will be imposed shortly upon hedge fund advisers (or possibly upon the funds themselves according to the comments of some regulators – an even greater challenge given the demands of the 40 Act).  Right now I’m dealing with the twin challenges of first mastering the mechanics of installing and configuring the required software and then creating the actual content of this blog.  While it may seem that the order of these tasks is reversed, in practice it certainly seems like the former is taking precedence.

Luckily, between the excellent platforms provided by WordPress and Thesis, and the seemingly endless content being generated by developments in the current Administration, the Congress and the markets, I’m confident that these challenges can both be overcome and more and “meatier” postings will be added in the near future.

So I ask that you please stay tuned in as the work progresses!

©2012 Hedge Fund Regulation. All Rights Reserved.

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The primary authority governing U.S. hedge fund advisers is found in the Investment Advisers Act of 1940 (generally called the Advisers Act), but additional requirements can arise under the Securities Act of 1933 (33 Act), the Securities Exchange Act of 1934 (34 Act), and the Investment Company Act of 1940 (40 Act). Depending on the nature of their businesses, advisers also must be aware of the requirements of the Commodity Exchange Act, the Gramm-Leach-Bliely Act (GLBA), the Employee Retirement Security Act (ERISA), and applicable State laws. Beyond the statutory requirements, adviser conduct is governed by the corresponding regulations issued by the SEC and the CFTC and by industry self regulating organizations (SROs) like FINRA and the NFA. Additional guidance is provided by various industry and government-sponsored advisory groups like the President’s Working Group (Best Practices for the Hedge Fund Industry [pdf]), the Alternative Investment Management Association (Guides to Sound Practices), the Managed Funds Association (Sound Practices for Hedge Fund Management [pdf]), and the International Organization of Securities Commissioners (Hedge Funds Oversight [pdf]).

The chart below and the accompanying table present a general overview showing how the major categories of regulation map to the business processes of an investment manager:

Each lettered flag in the diagram above corresponds to an area of regulation that is applicable to investment advisers in general, and hedge fund advisers in particular. The corresponding regulatory categories, with links to relevant postings in this blog, are listed below.

INDEX: Areas of Hedge Fund Regulation:

1. Registrations
2. Employee Conduct
3. Public Communications / Solicitations
4. Investor Relations (including AML)
5. Investment Decision-Making
6. Executing Fund Transactions
7. Risk Management
8. Investment Constraints
9. Processing Fund Transactions
10. Safekeeping Fund Assets
11. Investor Communications
12. Investor privacy and security
13. Record Keeping
14. Regulatory Reports and Filings
15. Performance Measurement
16. Firm Financial Management
17. Compliance Environment
18. Compliance Supervision
19. Proprietary Firm Trading
20. Valuation
21. Market Research
22. Business Continuity Planning (not shown above)
23. Other Applicable Bodies of Law (not shown above)

Other Topics Covered in Postings (not shown above):

• Hedge Fund Regulatory Requirements in General
• Industry History
• Business of Hedge Funds

Advisers managing registered investment companies also must satisfy the requirements of the 40 Act in respect to those funds.

Besides the above bodies of regulation which apply specifically to investment management, each hedge fund adviser needs to comply with legal constraints applicable to businesses in general, such as antitrust law, Sarbanes Oxley, employment and labor laws, and the general bodies of law governing financial and other crimes.

This overview is meant to serve only as an introduction to the breadth of requirements facing an adviser. Each firm will need to consult its legal counsel to adapt and interpret the business categories and flows shown above, as well as determining whether other constraints need to be considered, to address the content, volumes and nature of the adviser’s specific business activities.

©2012 Hedge Fund Regulation. All Rights Reserved.

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