US Securities and Exchange Commission

The impact of the SEC's recent move to extend its regulatory reach

Ralph Lindeyer, The CCL Partnership LLP

The SEC is set to hit the managers of pooled investments with a potential double whammy in February 2006. Firstly the SEC is to remove the Private Adviser Exemption for pooled investment vehicles, including Hedge Funds, meaning registration could soon become mandatory for many investment managers (termed advisers in US parlance). The second is the extension of the SEC reach to non-U.S. jurisdictions.

The SEC has recently confirmed that any manager with more than 14 US clients within the previous 12 months and with $30 million or more under management, will be required to register with the SEC by February 2006 under the Investment Advisers Act 1940. This has set alarm bells ringing in many non-US domiciled hedge fund managers.

This article provides some background to the changes and how to comply with them.

The SEC estimates the value invested in hedge funds is approaching $1 trillion, which represents a fifteen-fold increase over the past 10 years. With such an increase, the SEC is keen to limit fraud within hedge funds, provide more accurate information on the industry, and maintain its continuing obligation to increase the confidence of consumers in the U.S. securities markets.

Up to now many investment managers have been able to take advantage of an exemption referred to as the "Private Adviser Exemption" under Rule 203(b)(3)1. Under this exemption, the manager could treat a fund as a single client if it manages it based on the objectives of the fund and not the individual investment objectives of any investor. The SEC now requires a "look through" to the number of underlying investors, thereby bringing the majority of unregistered advisers within the scope of regulation .

Whilst 40% of hedge fund managers are already registered, this new requirement brings the vast majority of the remainder within the scope of regulation. It has brought fears of an increased cost to the industry, in particular to those overseas advisers not previously needing regulation in the US. The SEC's filing fees are relatively modest at approximately $1000 in the first year and $500 in successive years. The real cost is meeting the additional compliance burden. In order to register with the SEC, an applicant must provide systems and procedures that meet its requirements. This will necessitate many firms adapting their systems and procedures and will add to the costs of maintaining ongoing compliance. The SEC estimate an initial compliance cost of $20,000 in professional fees and $25,000 in internal costs.

The SEC is quick to point out that, as mentioned previously, many hedge fund advisers (2,500 of which are classed as 'smaller' by the SEC) are already registered, suggesting that registration and compliance is not such a burden to the hedge fund manager as was once feared. The SEC is of the opinion that the existing registered smaller firms are absorbing the compliance cost successfully, and therefore all firms will be able to cope with the increased cost. However, this makes no recognition of the overseas manager who might already be regulated by a respected regulator such as the FSA and to whom the SEC regulation would be considered to be an unreasonable additional burden that provides no economic benefit to the firm or protection to the investor.

Fortunately, there are certain exemptions to the amendments for non-US hedge fund managers.

Non-US firms managing closed offshore funds are able to treat those funds as its clients rather than the underlying clients for all purposes except for the requirement to register and the anti-fraud provisions. US based managers must count all investors, US and non-US in determining the registration threshold.

The SEC is also apprehensive about the changes, recognising that they have limited funds to devote to the task of monitoring the industry; funds which perhaps could be used more effectively elsewhere to achieve the SEC's overall goal of increased protection in the US. For example, ninety million Americans invest in mutual funds as against the estimated 200,000 sophisticated high net worth individuals and larger institutions that currently invest in hedge funds.

Concerns have also been raised over the possibility that registration under the Investment Advisers Act will create a false sense of security. The SEC is not a seal of quality in relation to its members or their investments. The SEC addresses this issue by prohibiting managers from making any representation that SEC has recommended or approved them.

Once registered, advisers are required to comply with the rules under the Adviser Act such as: books and records; custody; proxy voting; compliance and the code of ethics.

UK managers will be familiar with the spirit of financial promotions, including the requirement for a manager wishing to make claims concerning its past performance to keep documentation supporting these claims for 5 years.

The books and records requirement of registered investment vehicles includes all the records of the private funds for which the adviser acts as a general partner, managing member or in a similar capacity.

However it is not all bad. The SEC has recognised in the past that hedge funds have encountered difficulty in obtaining completion of their fund audits and has responded by changing the requirements. In order to enable hedge fund advisers to comply with the custody rules it has proposed that the period in which pooled investment vehicles have to distribute their audited financial statement be extended from 120 days from the fiscal year end, to 180 days.

The industry may be divided over the merits of the increased regulation, with particular reference to fears regarding the expense; record keeping, and the notion that perhaps the aim of protecting the US investor could be better served elsewhere. There can be no doubt that the burden for overseas managers who are already regulated will increase. However, the SEC's opinion is robust and characterised by the words of its chairman, William Donaldson, when he observed, in July 2004, "I don't get much push back from people who have nothing to hide."