Speech by SEC Staff:
Regulating Hedge Funds and Other Private Investment Pools
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
New York, New York
February 19, 2010
Thank you for inviting me to speak at the Fordham Journal of Corporate and Financial Law's 3rd Annual Symposium on the Regulation of Investment Funds. I look forward to a spirited discussion of the current regulatory proposals affecting hedge funds and other private funds. I remind you that any views I express today are my own and not necessarily those of the Commission, the individual Commissioners, or my colleagues on the Commission staff.
Today I would like to discuss the regulation of private funds through their advisers and the persons selling private funds to investors. You will see that there are gaps in this regulation currently. I will also briefly cover international cooperation in the regulation of private fund managers.
The US securities laws have not kept pace with the growth and market significance of hedge funds and other private funds and, as a result, the Commission has very limited oversight authority over these vehicles. Sponsors of private funds—typically investment advisers—are able to organize their affairs in such a way as to avoid registration under the federal securities laws. The Commission only has authority to conduct compliance examinations of those funds and advisers that are registered under one of the statutes the Commission administers. Consequently, advisers to private funds can "opt out" of Commission oversight.
This presents a significant regulatory gap in need of closing. The Commission tried to close the gap in 2004—at least partially—by adopting a rule requiring all hedge fund advisers to register under the Investment Advisers Act of 1940.2 That rulemaking was overturned by an appellate court in the Goldstein decision in 2006.3 Legislative action is needed at this time to enhance regulation in this area.
Advisers Act registration, coupled with existing law regulating persons selling private funds, would, I believe, provide the Commission with needed tools to provide oversight of this important industry in order to protect investors and the securities markets, without impeding the investment strategies of these funds. Today, I wish to discuss how registration of advisers to private funds under the Advisers Act would greatly enhance the Commission's ability to properly oversee the activities of private funds and their advisers. I would also like to discuss the regulation of the people selling private funds, because that is an important element for ensuring that only the appropriate types of investors participate in these funds.
Current Regulatory Exemptions
Although hedge funds, private equity funds and venture capital funds reflect different approaches to investing, legally they are indistinguishable. They are all pools of investment capital organized to take advantage of various exemptions from registration. Other than the "qualified purchaser" exemption, all of these exemptions were designed to achieve some purpose other than permitting private funds and their advisers to avoid registration.
Private funds typically avoid registration of their securities under the Securities Act of 1933 by conducting private placements under section 4(2) and Regulation D.4 As a consequence, these funds are sold primarily to "accredited investors," the investors typically receive a "private placement memorandum" rather than a statutory prospectus, and the funds do not file periodic reports with the Commission. In other words, they lack the same degree of transparency required of publicly offered issuers, on the theory that these investors can "fend for themselves."
Private funds seek to qualify for one of two exemptions5 from regulation under the Investment Company Act of 1940. They either limit themselves to 100 total investors (as provided in section 3(c)(1)) or permit only "qualified purchasers" to invest (as provided in section 3(c)(7)).6 As a result, the traditional safeguards designed to protect investors in the Investment Company Act are the subject of contractual arrangements in private funds. These safeguards include investor redemption rights, application of auditing standards, asset valuation, portfolio transparency and fund governance. They are typically included in private fund partnership documents, but are not required and vary significantly among funds.
The investment activities of a private fund are directed by its investment adviser, which is typically the fund's general partner.7 Investment advisers to private funds often claim an exemption from registration under section 203(b)(3) of the Advisers Act, which is available to an adviser that has fewer than 15 clients and does not hold itself out generally to the public as an investment adviser.
Section 203(b)(3) of the Advisers Act contains a de minimis provision that I believe originally was designed to cover advisers that were too small to warrant federal attention. The exemption now covers advisers with billions of dollars under management because each adviser is permitted to count a single fund as a "client." Interestingly, this exemption pre-dates the rise of hedge, private equity and venture capital funds. The Commission recognized the incongruity of the purpose of the exemption with the counting rule, and adopted a new rule in 2004 that required hedge fund advisers to "look through" the fund to count the number of investors in the fund as clients for purposes of determining whether the adviser met the de minimis exemption. This was the rule overturned by the appellate court in the Goldstein decision.
All advisers to private funds whether registered or not are subject to the anti-fraud provisions of the Investment Advisers Act, including an anti-fraud rule the Commission adopted in response to the Goldstein decision that prohibits advisers from defrauding investors in pooled investment vehicles.8 Registered advisers, however, are also subject to additional requirements as described below.
Ensuring that only appropriate, sophisticated persons invest in private funds is fundamental to their unregistered status. Beyond the formal investor qualification tests embedded in the funds' exemptions, broker-dealer regulation of intermediaries provides important protections for investors. Under the Securities Exchange Act of 1934, any person engaged in the business of effecting transactions in securities for the account of others must generally register as a broker-dealer. As with advisers, registration of broker-dealers provides important investor protections. Among other things, registered broker-dealers are subject to SRO suitability requirements and other sales practice regulation. Although there are exceptions to the registration requirement, they are narrowly drawn and, as a practical matter, the lawful receipt of compensation in connection with the purchase and sale of securities typically requires registration as, or association with, a registered broker-dealer.
I am concerned that some participants in the private fund industry may be inappropriately claiming to rely on exemptions or interpretive guidance to avoid broker-dealer registration. In so doing, these participants may be creating a de facto gap in broker-dealer regulation in addition to the legislative gap in Commission authority with respect to adviser regulation. Persons who are not currently registered as, or associated with, a broker-dealer should carefully consider whether they should be.
Registration of Private Fund Investment Advisers
Legislative proposals under consideration would address the legislative gap in adviser registration by eliminating Section 203(b)(3)'s de minimis exemption from the Advisers Act. Investment adviser registration would be beneficial to investors and our markets in several important ways.
1. Accurate, Reliable and Complete Information
Registration of private fund advisers would provide the Commission with the ability to collect data from advisers about their business operations and the private funds they manage. The Commission would thereby, for the first time have accurate, reliable and complete information about the sizable and important private fund industry that could be used to better protect investors and market integrity. Significantly, the information collected could include systemic risk data, which could then be shared with other regulators.
2. Enforcement of Fiduciary Responsibilities
Advisers are fiduciaries to their clients. Advisers' fiduciary duties are enforceable under the anti-fraud provisions of the Advisers Act. They require, among other things, that advisers avoid conflicts of interest with their clients, or fully disclose the conflicts to their clients. Registration under the Advisers Act gives the Commission authority to conduct on-site compliance examinations of advisers designed, among other things, to identify conflicts of interest and determine whether the adviser has properly disclosed them. In the case of private funds, it gives a regulator an opportunity to determine facts that most investors in private funds cannot discern for themselves. For example, investors often cannot determine whether fund assets are subject to appropriate safekeeping or whether the performance represented to them in an account statement is accurate. In this way, registration may also have a deterrent effect because it would increase an unscrupulous adviser's risk of being discovered.
3. Prevention of Market Abuses
Registration of private fund advisers under the Advisers Act would permit oversight of adviser trading activities to prevent market abuses such as insider trading and market manipulation, including improper short-selling.
4. Compliance Programs
Private fund advisers registered with the Commission are required to develop internal compliance programs administered by a chief compliance officer. Chief compliance officers help advisers manage conflicts of interest the adviser has with or among its clients, including private funds. Examination staff resources are limited and cannot be at the office of every adviser at all times. Compliance officers serve as the front-line watch for violations of securities laws, and provide protection against conflicts of interests.
5. Keeping Unfit Persons from Using Private Funds to Perpetrate Frauds
Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or engaged in securities fraud.
6. Scalable Regulation
In addition, many private fund advisers have small to medium size businesses, so it is important that any regulation take into account the resources available to those types of businesses. Fortunately, the Advisers Act has long been used to regulate both small and large businesses, so the existing rules and regulations already account for those considerations. In fact, roughly 69 percent of the investment advisers registered with the Commission have 10 or fewer employees.
7. Equal Treatment of Advisers Providing Same Services
Under the current law, an investment adviser with 15 or more individual clients and at least $30 million in assets under management must register with the Commission, while an adviser providing the same advisory services to the same individuals through a limited partnership could avoid registering with the Commission. Investment adviser registration, in my view, is appropriate for any investment adviser regardless of the form of its clients or the types of securities in which they invest.
Avoiding New Gaps
While the legislation being discussed does close some gaps in regulation, in my opinion some of the provisions would unfortunately create new gaps. The various bills provide exemptions for advisers to private equity and venture capital funds as well as private fund advisers with less than $150 million in assets under management. Those provisions do contemplate that the advisers would be subject to recordkeeping and reporting requirements, which are important elements of adviser regulation. However, as unregistered advisers they would avoid other provisions that are vital to the investor protections afforded by the Advisers Act. For example, the Commission would not have the ability to keep convicted felons from associating with these advisers, and the advisers would not be subject to the compliance rule.
The Commission's 2004 rulemaking was limited to hedge fund advisers. However, since that time, the lines that may have once separated hedge funds from private equity and venture capital funds have blurred, and the distinctions are often unclear. The same adviser often manages funds pursuing different strategies and even individual private funds often defy precise categorization. Moreover, I am concerned that in order to escape Commission oversight, advisers may alter fund investment strategies or investment terms in ways that will create market inefficiencies. This happened following the Commission's 2004 rulemaking when advisers lengthened the lock up imposed on investors in order to avoid registration. In addition, Ponzi scheme operators are likely to gravitate to less regulated spaces in the investment management industry. Those that have falsely claimed to be hedge funds until now could just as easily claim to be a venture capital fund tomorrow. And they would have a much longer window before investors expected to see any cash.
International Cooperation and the Proposed EU Directive
Europe is also looking at the regulation of hedge funds and other private funds through new European legislation in the form of the proposed Alternative Investment Fund Managers Directive. A new directive was first proposed by the European Commission in the spring of 2009.9 Various possible changes are being discussed by the European Council and European Parliament.10
The main proposals that have been published in Europe so far resemble the US legislative proposals in some respects. For example, they focus on regulating the manager, or adviser, to the hedge or other private fund instead of regulating the fund directly. Also, there is a debate about the scope of the directive with respect to private equity and venture capital funds. Not surprisingly, however, the European proposals differ in some ways from those in the United States. For example, the European proposals require alternative fund managers to maintain specified levels of capital and have risk management programs.
Another important distinction is how the US and EU regimes apply to advisers physically based outside of their territory. The Advisers Act registration requirements generally apply to non-US advisers if they have US clients. Under long-standing SEC staff interpretations, a non-US, SEC-registered adviser need only apply many Advisers Act requirements to its dealings with US clients. Under this position, a non-US private fund adviser without direct US clients, such as a foreign adviser to offshore funds with US investors, may treat the fund as its client for most purposes under the Adviser Act, simplifying compliance.11 Non-US advisers wishing to manage money for US persons may elect to subject themselves to these proportionate and tailored regulatory requirements, regardless of the requirements of the adviser's home regulator.
The application to non-EU managers, including US managers, of the proposed EU directive varies significantly among the published versions. However, various proposals appear to require that the adviser's home country regulator have a regulatory system that is deemed to be "equivalent" to Europe's, or that contains specified elements from the European proposal, in order for the adviser to manage assets raised from European investors. The proposals do not appear to contemplate that a non-EU manager could elect to register with an EU regulator. In effect, these proposals may impose requirements on the adviser's regulator, instead of on the adviser itself. As a result, these proposals seem likely to exclude some non-EU managers, including potentially US advisers, even if those managers are willing to follow the European requirements.
I believe countries should work together on a multilateral and cooperative basis to ensure consistently high standards. For example, the Commission staff has been working with the UK FSA and IOSCO to develop a template for the collection of consistent and comparable data from hedge fund managers.12 However, I do not believe this means that we must, as regulators, in all cases apply identical standards.
The registration and oversight of private fund advisers, without exemptions based on strategy, would provide transparency and enhance Commission oversight of the capital markets. It would give regulators, for the first time, reliable and complete data about the impact of private funds on our securities markets. It would give the Commission access to information about the operation of hedge funds and other private funds through their advisers. It would permit private funds—which play an important role in our capital markets—to retain the current flexibility in their investment strategies. Coupled with the application of existing requirements to those persons selling private funds, adviser registration would help ensure investor protection. Internationally, all countries should achieve high quality and similar outcomes in our regulatory and supervisory practices, but countries should not impose standards on one another if they are not identical.