Senate Committee on Banking, Housing & Urban Affairs

Regulating hedge funds and other private investment pools

Originally published in the August 2009 issue

The US Senate Banking Subcommittee on Securities held a hearing on 16th July 2009 to discuss how to improve federal oversight of hedge funds and other private pools of capital. The hearing came just a month after the Obama administration unveiled its white paper on regulatory reform recommending that hedge fund managers register with the US Securities and Exchange Commission (SEC). The following are extracts from the testimony of four of the speakers.

Andrew J. Donohue, Director, SEC

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

The Commission has incomplete information about the advisers and private funds that are participating in our markets. It is not uncommon that our first contact with a manager of a significant amount of assets is during an investigation by our Enforcement Division. The data that we are often requested to provide members of Congress (including the data we provide above) or other federal regulators are based on industry sources, which have proven over the years to be unreliable and inconsistent because neither the private funds nor their advisers are required to report even basic census-type information. This presents a significant regulatory gap in need of closing. The Commission tried to close the gap in 2004 – at least partially – by adopting a rule requiring all hedge fund advisers to register under the Investment Advisers Act of 1940. That rulemaking was overturned by an appellate court in the Goldstein decision in 2006.

Since then, the Commission has continued to bring enforcement actions vigorously against private funds that violate the federal securities laws, and we have continued to conduct compliance examinations of the hedge fund advisers that remain registered under the Advisers Act. But we only see a slice of the private fund industry, and the Commission strongly believes that legislative action is needed at this time to enhance regulation in this area.

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

Registration of private fund investment advisers

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

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

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

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

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

5. Keeping unfit persons from using private funds to perpetrate frauds
Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or engaged in securities fraud.

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

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

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

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

James Chanos, Chairman, Coalition of Private Investment Companies

What legislative changes are needed?
As this Subcommittee is aware, private investment companies and their advisers are not required to register with the SEC if they comply with the conditions of certain exemptions from registration under the Investment Company Act and the Advisers Act. Congress created exemptions under these laws, because it determined that highly restrictive requirements applicable to publicly-offered mutual funds and advisers to retail investors were not appropriate for funds designed primarily for institutions and wealthy investors.

To date, legislative proposals to regulate private investment companies have focused on limiting the exemptions from regulation of private investment companies under the Investment Company Act or removing an exemption under the Advisers Act and thus subjecting private investment companies or their advisers to the requirements of one of those Acts. Although I agree that private investment companies and their managers should be subject to additional regulatory requirements to protect investors and counterparties, I believe simply eliminating the exemptions in either or both of these statutes will prove unsatisfactory.

The first lesson we all learned in shop class was to use the right tool for the job. Neither the Investment Company Act nor the Advisers Act in its current form is the right tool for the job of regulating hedge funds and other private investment companies. They do not contain the provisions needed to address the potential risks posed by the largest large private investment companies, the types of investments they hold, and the contracts into which they enter. At the same time, those laws each contain provisions designed for the types of businesses they are intended to regulate – laws that would either be irrelevant to oversight of private investment companies or would unduly restrict their operation.

The Advisers Act and the Investment Company Act (which applies primarily to the retail mutual fund sector), are both designed primarily for retail investor protection in individual accounts that invest in publicly-traded stocks and bonds. Neither has specific provisions designed to protect funds’ counterparties or control systemic risk. Many requirements of the Advisers Act are irrelevant, or would be counterproductive, if applied to private investment companies. For example, Advisers Act restrictions on transactions with affiliates conducted as principal that require client consent on a transaction-by-transaction basis may work against investors’ needs by impinging on a fund’s ability to seize rapidly emerging opportunities, particularly in the cases of private equity and venture capital funds. Such funds routinely conduct transactions as principal or as a co-investor alongside affiliated funds, and transaction-by-transaction consents from large numbers of private fund investors are, as a practical matter, not possible to collect.

In addition, the SEC’s custody rules under the Advisers Act are insufficient to protect private investment fund assets from theft or prevent other forms of fraud. Although the SEC recently proposed amendments to these rules, even as proposed to be amended, the rules do not fully protect the assets of private investment funds. For example, the rules exclude from custody requirements certain types of instruments that are commonly owned by private investment funds, an exclusion that would deprive investors in those funds of the protection that a custodian provides. Access control requirements under the rules are rudimentary at best, particularly for assets other than publicly-traded securities.
Detailed formal requirements on the means by which private investment fund assets enter and exit the custodian’s control are needed to assure that the fund’s assets really exist and cannot easily be stolen.
Moreover, the Advisers Act is generally silent on methods for winding down an investment fund or client account, an area which the law should address in some detail for large private investment companies. In sum, the Advisers Act, which was adopted in largely its current form in 1940, is not well suited to today’s investment structures, strategies, and qualified investors’ needs.

Neither is the Investment Company Act suited for regulation of private funds. As an example, requirements for boards of directors set by the Investment Company Act are designed to protect the large numbers of retail investors in mutual funds, and are a poor fit for vehicles that are offered only to select groups of high net worth and institutional investors. Similarly, the Investment Company Act generally provides for either daily liquidity (mutual funds for which investors can redeem shares every business day), or no liquidity (closed-end funds for which investors can rarely be redeemed out), while private investment funds are able to adopt a flexible range of redemption dates to address the liquidity of the assets in which the particular fund invests.

Scope of S. 1276
The Chairman’s bill, S. 1276, would require registration under the Advisers Act for those private fund managers that have $30 million or more under management. It would also provide that records of the adviser’s related private funds (those exempted under sections 3(c)(1) and 3(c)(7) of the Investment Company Act) are deemed to be records of the adviser and subject to SEC inspection. Thus, under the bill, the SEC would have full authority under the Advisers Act over all private fund managers (other than foreign advisers) meeting the specified threshold, and would have broad inspection authority over all records of private funds, even though the funds themselves would not be registered.

The legislation further amends existing section 211 of the Advisers Act to enhance the SEC’s authority to adopt different sets of rules to address different types of advisers. Under this authority, the SEC could, for example, write a set of rules under the Advisers Act applicable only to advisers to private funds and tailored for those advisers. The bill, therefore, offers a creative and flexible approach to regulation of private investment fund managers and oversight of the funds themselves.

However, you may wish to consider whether the bill, as drafted, provides too little direction from Congress – both as to what elements of the Advisers Act should be modified or omitted with respect to private funds, and what additional requirements, going beyond those currently applicable to registered investment advisers, should be added for advisers to private funds and for the funds themselves. Indeed, the legislation, as currently drafted, could leave some doubt as to how broadly Congress intends the SEC to act in this area.

We therefore recommend that Congress consider developing a Private Investment Company Act, which would contain targeted controls and safeguards needed for oversight of private funds, while preserving their operational flexibility. More detailed requirements could be considered for large private investment companies (or families of private investment companies) in order to address the greater potential for systemic risk posed by such funds, depending upon their use of leverage and their trading strategies. If you choose not to develop a separate act for private funds and use the approach of S. 1276 regulating private investment funds under the Advisers Act, we suggest that the legislation further direct the SEC to use its authority under Section 211 and tailor the requirements of the Advisers Act to impose appropriate requirements on private investment funds. We believe the legislation should specify those requirements.

Prevention of theft, Ponzi schemes, and fraud
Any new private fund legislation should include provisions to reduce the risks of Ponzi schemes and theft by requiring money managers to keep client assets at a qualified custodian, and by requiring investment funds to be audited by independent public accounting firms that are overseen by the Public Company Accounting Oversight Board. Custody requirements should be extended to all investments held by covered funds. Fund assets should be held in the custody of a bank, registered securities broker dealer, or (for futures contracts) a futures commission merchant. While the SEC has adopted custody rules for registered advisers pursuant to its antifraud authority under the Advisers Act (and recently proposed amendments to those rules) we believe Congress should provide specific statutory direction to the SEC to adopt enhanced custody requirements for all advisers.

Private investment companies have operated remarkably well in the absence of direct government oversight and subject to the due diligence of large and sophisticated investors. CPIC nonetheless supports the call for enhanced oversight, with the SEC as the primary functional regulator. But, simply imposing new regulation without properly tailoring it to address the relevant risks would add to the burdens of hard-working, but already overstretched agency staffs. Moreover, simply requiring registration under the Advisers Act or Investment Company Act could degrade investor due diligence by causing undue reliance upon SEC regulation under statutes that are insufficiently robust to address the unique characteristics of private funds. We believe that the twin goals of improved investor protection and enhanced systemic oversight could be better achieved with a stand-alone statute, tailored for private investment funds. If this Subcommittee determines, however, to bring private funds under SEC oversight by requiring fund managers to register under the Advisers Act, we believe that any such legislation should include the key provisions discussed above.

Dinakar Singh, Founding Partner, TPG Axon Capital on behalf of the Managed Funds Association (MFA)

Registration and regulation
In adopting a smart and effective approach to the regulation of managers of private pools of capital, it is important to recognize that many, if not all, of these regulatory issues will be relevant to all such managers, including firms that manage hedge funds, private equity funds, venture capital funds and real estate funds. The Obama Administration, in its release Financial Regulatory Reform A New Foundation: Rebuilding Financial Supervision and Regulation (the Administration Proposal), is supportive of this approach, calling for the registration of advisers of hedge funds and other private pools of capital with the SEC. MFA and its members support the Administration’s proposal to require the registration of investment advisers to all private pools of capital, subject to a limited exemption for the smallest investment advisers with a de minimis amount of assets under management. We believe that a registration framework under the Advisers Act is the smart approach to registration and regulation of managers to private pools of capital.

MFA and its members have publicly supported this comprehensive approach to adviser registration over the past several months, even when the Administration called for a narrower registration requirement only for advisers to the largest and most systemically relevant private pools of capital. We strongly encourage policy makers also to consider the issue of registration in the context of all private pools of capital and the managers of those pools. Likewise, we strongly encourage regulators to consider regulations that apply to all private investment firms and not just hedge fund managers. This approach will both promote better regulation as well support the many benefits private investment firms provide to the US markets.

MFA and its members recognize that mandatory SEC registration for advisers of private pools of capital is one of the key regulatory reform proposals being considered by policy makers. We believe that the approach set out in the Administration Proposal of registering investment advisers, including advisers to private pools of capital, under the Investment Advisers Act of 1940 is the right approach in considering this issue. In fact, more than half of MFA member firms already are registered with the SEC as investment advisers. Applying the registration requirement to all investment advisers, instead of focusing solely on hedge fund managers, is also a smart approach to registration. We believe that removing the current exemption from registration for advisers with fewer than 15 clients would be an effective way to achieve this result. The form and nature of registration and regulation of investment advisers to private pools of capital should be evaluated in the context of how to best promote investor protection, market integrity and systemic risk monitoring, each of which may be best achieved by different types of regulation.

We believe that the Advisers Act provides a meaningful regulatory regime for registered investment advisers. The responsibilities imposed by Advisers Act registration and regulation are not taken lightly and entail significant disclosure and compliance requirements, including:

• Providing publicly available disclosure to the SEC regarding, among other things, the adviser’s business, its clients, its financial industry affiliations, and its control persons;
• Providing detailed disclosure to clients regarding, among other things, investment strategies and products, education and business background for adviser personnel that determine investment advice for clients, and compensation arrangements;
• Maintaining of books and records relevant to the adviser’s business;
• Being subject to periodic inspections and examinations by SEC staff;
• Adopting and implementing written compliance policies and procedures and appointing a chief compliance officer who has responsibility for administering those policies and procedures;
• Adopting and implementing a written code of ethics that is designed to prevent insider trading, sets standards of conduct for employees reflecting the adviser’s fiduciary obligations to its clients, imposes certain personal trading limitations and personal trading reports for certain key employees of the adviser; and
• Adopting and implementing written proxy voting policies.

Though the Advisers Act already provides a meaningful regulatory framework for investment advisers, MFA and its members have been working with policy makers to explore ideas for possible enhancements to the Act. These enhancements are designed to ensure that regulators have appropriate authority to conduct meaningful oversight over and regulation of investment advisers to private pools of capital and the pools (funds) that those advisers manage. In particular, MFA and its members have been working to develop proposals that will ensure regulators have appropriate transparency regarding private funds and have the authority and tools necessary to prevent fraud. We believe that an enhanced Advisers Act regulatory framework is the most effective means to achieve those goals, and we are committed to working with policy makers on developing that framework.

In addition to registration and regulation of advisers through the Advisers Act, the hedge fund industry is subject to other, meaningful regulatory oversight. Hedge funds, like other market participants, are subject to existing, extensive trading rules and reporting requirements under the US securities laws and regulations. Increasing investor confidence and promoting market integrity are carried about by the SEC and other regulators through these regulatory requirements.

With a comprehensive registration framework comes additional burdens on federal regulators. A registration framework that overwhelms the resources, technology and capabilities of regulators will not achieve the intended objective, and will greatly impair the ability of regulators to fulfil their existing responsibilities, as well as their new responsibilities. Regulators must have adequate resources, including the ability to hire and retain staff with sufficient experience and ability, and improve the training of that staff, to properly oversee the market participants for whom they have oversight responsibility. The SEC, which is the existing regulator with oversight of investment advisers, has acknowledged that its examination and enforcement resources are already seriously constrained. This raises the question whether the SEC would have the resources or capability to be an effective regulator when advisers to private pools of capital are required to register under an expanded registration framework. We encourage policy makers to consider the issue of resources and regulatory capabilities as they develop proposals for an expanded regulatory mandate.

Joseph A. Dear, Chief Investment Officer, California Public Employees’ Retirement System

What benefits do private pools of capital – including hedge funds, private equity funds and venture capital funds – provide to financial markets, investors, and the broader economy?

Hedge funds, private equity and other pools of private capital provide:
• Useful components of a diversified investment portfolio to enhance returns and add effective risk management tools.
• The ability to bring together like minded investors that have been committing long term capital to a number of investment areas.
• More flexibility to invest in accordance with opportunities in contrast to being limited to a particular category or “style.”
• Benefits to the larger financial system including innovation, gains in growth and employment and the provision of capital for economic and technological advancement.

What risks do private pools of capital pose to financial markets and the broader economy?

The fundamental risk posed by private pools of capital is that they can choose to operate outside the regulatory structure of the US. When these entities operate in the shadows of the financial system, regulatory authorities lack basic information about exposures, leverage ratios, counterparty risks and other information necessary to assure that overall risk levels in the financial system are reasonable. Moreover, without the disclosure, reporting and licensing requirements that accompany registration, investors may be deprived of the timely and accurate information they need to ascertain the suitability of an investment fund given their financial objectives and risk tolerance.

Clearly, the buildup of massively leveraged positions was enabled by the absence of any effective regulatory oversight. Combined with misaligned compensation practices that, among other things, encouraged excessive risk taking by rewarding short term success without penalty for subsequent losses, the result was an unprecedented degree of risk in the system. The harm that has ensued as overleveraged investors have had to unwind their positions extends far beyond them and their investors, to other market participants and ultimately to the national economy as a whole.

What approaches by market participants and regulators can best reduce these risks, without unduly limiting the benefits of such funds?

Policy makers, investors, regulators and the public need to accept that risk is inevitable and necessary; return without risk is like love without heartache – they go together. If risk cannot be avoided then it has to be managed.

One of the powerful lessons of the crash for us was the limited value of many quantitative risk management tools. So an obvious imperative for us is to improve our quantitative and qualitative comprehension of the risks in our portfolio. In addition to better risk management, investors can improve the depth and detail of their due diligence, adhere scrupulously to best practices in decision making, and make timely disclosures of their investment policies, holdings and performance.

Regulators need new tools and authority to deal effectively with the gaps exposed by the crash. But not all of the regulatory shortcomings we see so clearly now are the product of gaps and omissions. Regulators also failed to use the authority they possessed to protect investors and assure the integrity of markets, exchanges and investment providers. Enforcement is not the only tool of effective regulatory systems, but its absence can dangerously weaken the credibility of those systems. Regulatory agencies need resources, support and leadership to make the most of the authority granted to them so they can fulfil their mission.

Institutional investors also need the flexibility to invest, consistent with their fiduciary responsibilities, in an unconstrained investment opportunity set. This is critical to enable public pension funds to meet our obligations. Limitations on the universe of available investments will potentially reduce our ability to generate the needed returns and may increase the risk of the plan.

What possible legislative changes are needed to ensure that activities of private pools of capital are sufficiently transparent, and that regulators have the tools they need to prevent fraud and reduce risks posed to the financial system?

• All investment managers of funds available to US investors should be required to register with the SEC as investment advisers and be subject to oversight.
• Existing investment management regulations should be reviewed to ensure they are appropriate for the variety of funds and advisers subject to their jurisdiction.
• Investment managers should have to make regular disclosures to regulators on a real-time basis, and to their investors and the market on a delayed basis.
• Investment advisers and brokers who provide investment advice to customers should adhere to fiduciary standards of care and loyalty. Their compensation practices should be reformed, and their disclosures should be improved.
• Institutional investors – including pension funds, hedge funds and private equity firms – should make timely, public disclosures about their proxy voting guidelines, proxy votes cast, investment guidelines, and members of their governing bodies and report annually on holdings and performance.