Speech by SEC Staff: What SEC Registration Means for Hedge Fund Advisers
Deputy Director, Office of Compliance Inspections and Examinations
U.S. Securities and Exchange Commission
New York City Bar
May 11, 2012
Thank you for inviting me to speak to you today. I am very pleased to be here. As you know, the views that I express here are my own and do not necessarily reflect those of the Commission or my colleagues on the staff of the Commission.
Today I will cover the following three topics: First, I will briefly discuss the provisions of the Dodd-Frank Act that are applicable to private fund advisers, specifically hedge fund advisers, and what the Commission staff and the National Examination Program have been doing to prepare for these new registrants.1 Second, I will highlight several key requirements under the Advisers Act as well as briefly discuss some important considerations for newly registered hedge fund advisers.2 Specifically, I will focus on the following three areas: fees, conflicts of interest and risk management. Third, I will cover certain areas for management at hedge fund advisers to consider.
Dodd-Frank Requirements for Advisers and the National Examination Program
Registration. Title IV of the Dodd-Frank Act eliminated the private adviser exemption.3 These private advisers, including advisers to hedge funds and private equity funds, are subject to the same registration, regulatory oversight and other requirements, such as examination, that apply to other SEC regulated investment advisers. These new registrants were required to register with the Commission by March 30, 2012.4
We at the NEP have been monitoring the Form ADV applications of new advisers as they have been filed. As of early April, there were approximately 4,000 investment advisers that manage one or more private funds registered with the Commission, of which 34% (more than 1,350) registered since the effective date of the Dodd-Frank Act, July 21, 2011. We estimate that this represents a 52% increase in registered private fund advisers; 32% of all advisers currently registered with the Commission report that they advise at least one private fund. Of the registered private fund advisers, approximately 7% (284) are domiciled in a foreign country; most of these (136) are in the United Kingdom. Registered private fund advisers report on Form ADV that they advise approximately 30,000 private funds with total assets of $8 trillion, which is 16% of total assets managed by all registered advisers.
Based on available information, we believe that 48 of the 50 largest hedge fund advisers in the world are now registered with the Commission. Fourteen of these largest hedge fund advisers are new registrants.
New Reporting Obligations. Pursuant to the Dodd-Frank Act, the SEC also adopted a rule requiring registered investment advisers (including advisers to hedge funds, private equity funds and liquidity funds) with at least $150 million in private fund assets under management to periodically file a new reporting form, Form PF.5 The information reported in Form PF will be used by the Financial Stability Oversight Council (FSOC) to monitor risks to the U.S. financial system and by the SEC to conduct risk assessments of private fund advisers. The type of information that is required to be disclosed on Form PF and the frequency of filing depends on whether the investment adviser is an adviser to private equity funds, hedge funds6 or liquidity funds and a “large private fund adviser,” which for a hedge fund adviser is an adviser with at least $1.5 billion in hedge fund assets under management.7
All investment advisers required to file a Form PF must provide basic information in Sections 1a and 1b. Section 1a requires indentifying information about the adviser and all related persons whose data is included, the large trader identification number, if any, the regulatory assets under management and net assets under management broken out by types of funds advised, and any assumptions made in responses to any question in Form PF. Section 1b requires information for each advised fund, including identifying information, gross and net asset values, investor concentration, borrowing and liquidity, and performance. There are also questions regarding a fund’s investment in other private funds and parallel managed accounts. Hedge fund advisers must disclose information about investment strategies, identification of significant credit risk, and trading and clearing practices in Section 1c.
Large private fund advisers must provide more detailed information than smaller advisers. Section 2a of Form PF requires that large hedge fund advisers disclose aggregate information regarding their hedge funds, including information regarding exposures by asset class, geographical concentration of investments held by funds and the monthly value of portfolio turnover by asset class. Section 2b requires that registered advisers that are large private fund advisers and advise at least one “qualifying hedge fund,” a hedge fund with a net asset value of at least $500 million, disclose information for each qualifying hedge fund relating to fund exposures, portfolio liquidity, unencumbered cash holdings, identification of the fund’s base currency, collateral practices with significant counterparties, risk metrics, market risk, concentration of positions, and trading and financing for each such hedge fund.8
Most hedge fund advisers must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after December 15, 2012. Hedge fund advisers, with at least $5 billion in assets under management attributable to hedge funds, must begin filing Form PF following the end of their first fiscal year or quarter, as applicable, to end on or after June 15, 2012.
Smaller hedge fund advisers will be required to file only annually within 120 days of the end of their fiscal year. Large hedge fund advisers will be required to file quarterly, within 60 days after the end of each fiscal quarter.
National Examination Program’s Plan for New Registrants
We at the NEP have been evaluating the unique risks presented by hedge funds and private equity funds based on a number of factors, including our past examination experience with these types of registrants and staff expertise. We are also looking to add staff with expertise in these areas.
We are evaluating the new information that we will be collecting on Form PF to help us identify where and how best to allocate our examination resources across existing and new registrants. We are also working to ensure the integrity of the confidential information internally, while also developing processes to ensure that examiners are given access to information that will provide them with a better understanding of an entity and allow for better scoping of exams.
Our strategy for these new registrants will include (i) an initial phase of industry outreach and education like today (sharing our expectations and perceptions of the highest risk areas), (ii) followed by a coordinated series of examinations of a significant percentage of the new registrants that will focus on the highest risk areas of their business and help us to risk rate the new registrants, and (iii) culminating in the publication of a series of “after action” reports, reporting to the industry on the broad issues, risks, and themes identified during the course of the examinations.
All of this will be planned and executed in consideration of the substantial existing responsibilities of the examination program with the goal, as always, of ensuring that we are optimally allocating our resources to fulfill the OCIE mission to improve compliance, prevent fraud, inform policy, and monitor industry-wide and firm-specific risks.
Important Considerations for Registered Hedge Fund Advisers
Obligations under the Advisers Act
Registration with the SEC imposes important obligations on newly registered advisers. Upon registration, advisers to hedge funds must comply with all of the applicable provisions of the Advisers Act and the rules that have been adopted by the SEC. These provisions require, among other things, adopting and implementing written policies and procedures, designating a chief compliance officer, maintaining certain books and records, filing annual updates of Form ADV, implementing a code of ethics and ensuring that advertising and performance reporting complies with regulatory rules. In addition, once registered, advisers become subject to examinations by the SEC.
Some of the compliance obligations include:
- The “Compliance Rule” requires registered advisers, including hedge fund advisers, to (a) adopt and implement written policies and procedures reasonably designed to prevent violation of the Advisers Act and rules that the Commission has adopted under the Advisers Act; (b) conduct a review, no less than annually, of the adequacy of the policies and procedures; and, (c) designate a chief compliance officer who is responsible for administering the policies and procedures.9
- The “Books and Records Rule” requires registered advisers, including hedge fund advisers, to make and keep true, accurate and current certain books and records relating to the firm’s investment advisory business. Generally, most books and records must be kept for five years from the end of the year created, in an easily accessible location.10
- Form ADV Updates—Rule 204-1 of the Advisers Act requires registered advisers to complete and file an annual update of Part 1A and 2A of the Form ADV registration form through Investment Advisers Registration Depository (IARD). Advisers must file an annual updating amendment to Form ADV within 90 days after the end of the firm’s fiscal year. In addition to annual filings, amendments must promptly be filed whenever certain information contained in the Form ADV becomes inaccurate.
- The “Code of Ethics Rule” requires a registered adviser to adopt a code of ethics which sets forth the standards of business conduct expected of the adviser’s supervised persons and must address the personal trading of their securities.11
- The “Advertising Rule” prohibits advertisements by registered advisers that are false or misleading or contain any untrue statements of material fact.12 Advertising, like all statements made to clients or prospective clients, is subject to the general prohibition on fraud under section 206 of the Advisers Act as well as other anti-fraud provisions under the federal securities laws. In addition to specific regulatory requirements, SEC Staff also has indicated its view that, if you advertise performance data, the firm should disclose all material facts necessary to avoid any unwarranted inferences.13
These are just some of the obligations for registered advisers under the Advisers Act and rules thereunder.
Special Considerations for Hedge Fund Advisers
It is important to note that investment advisers are “fiduciaries” to their advisory clients—the funds. This means that advisers have a fundamental obligation to act in the best interests of their clients and to provide investment advice in their clients’ best interests. Investment advisers owe their clients a duty of loyalty and good faith. Advisers to hedge funds should consider some of the following issues:
Fees/Expenses: As a fiduciary, it is important that hedge fund advisers allocate their fees and expenses fairly. A firm should clearly disclose to clientss the fees that it is earning in connection with managing investments as well as expense allocations between a firm and its client funds. Advisers should ensure the timeliness, accuracy and completeness of such reporting. A firm’s disclosure policies and procedures should address the allocation of their fees and expenses. Particular caution should be exercised when deals are undertaken among funds under common management and affiliated entities. In cases where two funds managed by the same investment adviser co-invest in the same investment vehicle, expenses should be allocated fairly across both funds.
Conflicts of Interest: Hedge fund advisers should identify any conflicts presented by the type and structure of investments their funds typically make, and ensure that such conflicts are properly mitigated and disclosed. Advisers of pooled investment vehicles also have a duty to disclose material facts to investors and prospective investors and failure to do so may constitute fraud.14 Examples of such conflicts are an adviser who failed to tell clients that it would receive additional commissions if they switched from one series of a fund to another15 and an adviser who failed to disclose to clients its investment of client funds in entities in which the advisers’ principals had interests.16 Fee structures can also lead to conflicts of interest. For example, conflicts of interest may arise when an adviser has the incentive to allocate trades to the hedge fund at the expense of affiliated mutual funds because of the opportunity for the investment adviser to earn greater profits from its management of hedge funds.
Risk Management: The management of conflicts of interest is just one part of good risk management. Hedge fund advisers should evaluate their risk management structures and processes by asking themselves the following types of questions. 1) Do the business units manage risks effectively at the product and asset class levels in accordance with the tolerances and appetites set by the board and senior management of the organization? 2) Are the key control, compliance and risk management functions effectively integrated into the structure of the organization while still having the necessary independence, standing and authority to effectively identify, manage and mitigate risk? 3) Does the firm’s internal audit processes independently verify the effectiveness of the firm’s compliance, control and risk management functions? 4) Do senior managers effectively exercise oversight of enterprise risk management? 5) Does the organization have the proper staffing and structure to adequately set its risk parameters, foster a culture of effective risk management, and oversee risk-based compensations systems and the risk profiles of the firm?
My Ten Suggested Takeaways for Registered Advisers to Hedge Funds
- Review your control and compliance policies and procedures annually. As a new registrant, you should undertake a comprehensive review of your operations to identify any gaps to your control and compliance policies and procedures. Make sure that they work for your organization. Update them if you have changes in your firm’s activities or products. Assign responsibility to specific persons/positions for maintaining the procedures. In addition to reviewing policies and procedures annually, which is required under Rule 206(4)-7, you should periodically test and verify procedures. For example, test and verify your valuation procedures and make sure your firm is consistent and following its procedures, especially for complex or illiquid securities.
- Assess and prepare for Form PF requirements. Form PF may require voluminous data. Hedge fund advisers may find that they do not maintain or collect all of the information that is required. Much of the information may be located in various places throughout the firm and some effort may be required to collect and report the information. Therefore, you need to begin now to identify the sources within the business where the data resides, determine how to best capture such data, collect and compile the data, and assure its accuracy.
- Identify risks. You should identify risk. Brainstorm any factors that create risk exposure for your clients and your firm.
- Enhance your expertise. Make sure your employees are knowledgeable about their work and that you have enough expertise to oversee what goes on. Continue to update and train your employees about new rules and procedures applicable to your firm and its products.
- Verify client assets. Be aware that examiners may verify some or all of your assets and the possibility that the examination staff will reach out to third parties and possibly clients in this process. Make sure your organization has done adequate due diligence in connection with third parties, including consultants and service providers.
- Get rid of any silos, identify conflicts. Get rid of silos and open communication among divisions and offices where appropriate and legally possible. I realize that in some situations barriers between certain areas of a firm are required legally. In particular, identify any situations where your interests may conflict with those of your clients. Make sure you manage those conflicts and disclose them to your clients.
- Provide clear, complete, and accurate disclosure in performance and advertising. Make sure you’ve made complete and accurate disclosure about performance, arrangements, fees, affiliates and affiliated transactions. Review marketing documents, client communications and questionnaire responses to ensure information is truthful, accurate and not misleading now that the JOBS Act permits general solicitation. Verify that fees are calculated correctly and accurately disclosed. Make sure you can trust the information, both external and internal, upon which you rely.
- Verify portfolio management compliance. Review client account holdings for appropriateness. Review trades for unusual performance relative to peers and markets. Compare trades to restricted lists and determine if trades were made ahead of publicly available news or research reports.
- Address your complaints. For complaints, make sure your procedures provide adequate instructions on handling them, and follow up to make sure they have been resolved.
- Check your IT security. Check your IT security to ensure that clients’ assets and information are not at risk.
1 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2 Unless otherwise noted, when we refer to the Advisers Act, or any paragraph of the Advisers Act, we are referring to 15 U.S.C. § 80b of the United States Code, at which the Advisers Act is codified, and when we refer to rule 203-1, rule 204(b)-1, rule 204-2, rule 204A-1, rule 204-4, rule 206, rule 206(4)-1, or rule 206(4)-7, or any paragraph of these rules, we are referring to 17 C.F.R. § 275.203-1, 17 C.F.R. § 275.204(b)-1, 17 C.F.R. § 275.204-2, 17 C.F.R. § 275.204A-1, 17 C.F.R. § 275.206, 17 C.F.R. § 275.206(4)-1, or 17 C.F.R. § 275.206(4)-7, respectively, of the Code of Federal Regulations (“C.F.R.”), in which these rules are published.
3 Section 403 of the Dodd-Frank Act. Title IV repealed the “private adviser exemption” contained in section 203(b)(3) of the Advisers Act on which many advisers, including those to many hedge funds, private equity funds and venture capital funds, relied in order to avoid registration under the Advisers Act. The adopting release, Rules Implementing Amendments to the Investment Advisers Act of 1940, Release No. IA-3221 (Jun. 22, 2011), 76 Fed. Reg. 42950 (Jul. 19, 2011) is available at: http://www.sec.gov/rules/final/2011/ia-3221.pdf.
4 Rule 203-1(e).
5 Rule 204(b)-1. The adopting release, Reporting by Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors on Form PF, Release No. IA-3308 (Oct. 31, 2011), 76 Fed. Reg. 71128 (Nov. 16, 2011), is available at: http://www.sec.gov/rules/final/2011/ia-3308.pdf.
6 Form PF defines a “hedge fund” generally as any private fund (other than a securitized asset fund) that (a) pays a performance fee or allocation calculated by taking into account unrealized gains (other than a fee or allocation the calculation of which may take into account unrealized gains solely for the purpose of reducing such fee or allocation to reflect net unrealized losses); (b) may borrow an amount in excess of one-half of its net asset value (including any committed capital) or may have gross notional exposure in excess of twice its net assets value (including any committed capital); or (c) may sell securities or other assets short or enter into similar transactions (other than for the purpose of hedging currency exposure or managing duration). Form PF: Glossary of Terms, at 4, available at http://www.sec.gov/rules/final/2011/ia-3308-formpf.pdf.
7 Form PF defines a “large hedge fund adviser” generally as an adviser and its related persons who collectively, have at least $1.5 billion in hedge fund assets under management as of the last day of any month in the adviser’s fiscal quarter immediately preceding its most recently completed fiscal quarter. Id. at 5.
8 Form PF defines a “qualifying hedge fund” as one that has a net asset value (individually or in combination with any feeder funds, parallel funds and/or dependent parallel managed accounts) of at least $500 million as of the last day of any month in the fiscal quarter immediately preceding the adviser’s most recently completed fiscal quarter. Id. at 8.
9 Rule 206(4)-7. The adopting release, Compliance Programs of Investment Companies and Investment Advisers, Release No. IA-2004, 68 Fed. Reg. 74,714 (Dec. 17, 2003)(“Compliance Programs Release”), is available at http://www.sec.gov/rules/final/ia-2204.htm
10 Rule 204-2.
11 Rule 204A-1.
12 Rule 206(4)-1.
13 Information for Newly-Registered Investment Advisers Information Sheet, available at http://www.sec.gov/divisions/investment/advoverview.htm
14 Rule 206(4)-8.
15 In re Valentine Capital Asset Mgmt., Release No. IA - 3090, 2010 WL 3791924 (Sept. 29, 2010) (settled administrative proceeding).
16 In re Sierra Fin. Advisors, LLC, Release No. IA - 3087, 2010 WL 3725370 (Sept. 23, 2010) (settled administrative proceeding).