Dodd-Frank Law Coaxes Hedge Funds into Regulatory Purview; States Expected to Carry a Large Part of the Load
The Dodd-Frank bill, signed into law on July 21, 2010, finally puts on the books a law meant to bring the vast majority of hedge funds under regulatory supervision. The law specifically requires “private fund advisers” to register, either with the SEC or their state of domicile.
Here’s roughly how the law works:
– Private Fund Advisers with between $25m and $100m in assets under management: must register with their state, unless exempt from state registration, or if the state does not call for examination of such advisers.
–Private Fund Advisers with over $100m in assets under management: must register with the SEC, unless they only advise private funds, in which case they can wait until they have over $150m in assets.
The key here to the effectiveness of the government’s efforts clearly lies in the states’ ability to provide oversight over the smaller advisers. To the extent a state’s law has gapping exemptions (as some of them do), smaller advisers will wind up not registering with either the state or the SEC. If we look at Hedge Fund Research (HFR) statistics for Q4 of 2008, we see that 53% of Firms have under $100m AUM; thus the importance of the state burden in this regulatory scheme is apparent.
Smaller hedge fund advisers must carefully evaluate their state law requirements to determine their registration requirements. Forth-coming rules from the SEC may also clarify some of the grey areas. The deadline for compliance with the registration requirements is within one year after the date of enactment.
The law can be viewed at http://docs.house.gov/rules/finserv/111_hr4173_finsrvcr.pdf
SEC Addresses Hedge Fund Pay-to-Play Issue
On the heels on several high profile scandals, the SEC has moved quickly to address “pay-to’play” practices in the hedge fund and investment advisory arenas. Last week, the SEC adopted new Rule 206(4)-5 limiting “pay-to-play” practices for investment advisers, including hedge fund investment advisers. The new Rule effectively prohibits the adviser from receiving compensation from any government entity for a two year period following a contribution to an elected official who controls that entity’s awarding of advisory business. Also prohibited are payments to unregistered third-party solicitors for solicitation of government entity advisory business.
For compliance professionals at hedge funds, the new Rule may require updating policies and procedures that address political contributions and the use of placement agents. Many hedge funds currently do not track employee political contributions. Keep in mind that the Rule prohibits “bundling” of contributions and that contributions up to two year’s prior to an employee’s start date of employment may be subject to the Rule restrictions. De minimis contibution amounts are allowed.
In adopting the new Rule, the SEC was primarily seeking to address how government pension plan investment advisory contracts are awarded, i.e., to ensure that those awarding the contracts fulfill their fiduciary duties. One of the highest profile scandals of this type involved David Loglisci, the chief investment officer at the New York State pension fund from 2003 to 2007. He admitted that he violated public trust in a kick-back scheme involving the awarding of investment contracts for the pension funds. Mr. Loglisci faces jail time.
The SEC release about the new Rule 206(4)-5 can be viewed at http://sec.gov/news/press/2010/2010-116.htm
Expansion of Compliance Industry is Forecast
“Compliance Officer” is one of the fastest growing occupations, according to the Department of Labor. Its forecast calls for exponential growth in this field, with a projected growth of 31% projected between 2008 and 2018. Expected employment in the compliance field is expected to be 341,000 by 2018.
This projection is not specific to the hedge fund industry, although it does include growth expected to occur within the financial services industry. As it pertains to hedge funds, the growth will occur in the hiring of chief compliance officers, internal support staff, as well as outsource compliance providers.
While universally viewed as a “good thing” for the hedge fund industry, there is a concern associated with these statistics. Specifically, will those hired to fill these additional positions in or for hedge funds possess the very specific skills that are necessary to adequately fulfill the job responsibilities? For example, could a compliance officer at an investment bank easily transition into a compliance officer role at hedge fund? Does a lawyer coming out of a general financial services practice at a law firm possess the skills to be a hedge fund chief compliance officer? Can a lawyer who specializes in broker-dealers also effectively provide compliance consultant services to a hedge fund?
Hiring and out-sourcing decisions at hedge funds need to be carefully considered. Skill sets must be analyzed carefully in order for a fund to hire the appropriate employee or consultant.
The Department of Labor report can be viewed at http://www.bls.gov/opub/mlr/2009/11/art5full.pdf
Hedge Fund Registration: How Much Will it Cost?
Registration of all the unregistered hedge fund investment advisers under the financial reform package…. how much will this cost?
That is a question that is puzzling both law-makers and the industry. For hedge funds, it is a personal question: how much will registration cost me? For law-makers and industry representatives, the question of course is a macro one for the industry as a whole.
To break it down on an individual level, and then aggregate up industry-wide, let’s look at the components of cost for a fund adviser that will be required to register under the proposed Dodd bill as it currently stands today (May 13, 2010). Here’s a look at categories of costs that will need to be covered. We won’t attempt to assign numbers at this point.
1. Cost of preparing the registration forms (the Form ADV): Do it yourself? Outsource to a law firm or consultant? Costs depend on degree of complexity of the fund group, and are not necessarily related to assets under management. In addition, there are on-going costs in this category related to the updating and annual amendments to these forms, as well as distribution costs.
2. Cost of hiring a Chief Compliance Officer: Add a new person to your payroll? Outsource the role? Assign it to someone within the organization as an “extra” duty? These are the choices, and costs vary accordingly. And of course, this is an on-going expense.
3. Cost of Preparing and Implementing Compliance Program: This will be a big ticket item. First there’s the cost of actually writing a compliance manual. Again, do it yourself? Outsource to a consultant or law firm? Then, there’s the cost of implementing the program, which is the real heart of the matter. This is a cost that is not so easily quantifiable. How much time will it take? How many people? What would they have been doing if they weren’t doing this?
4. Cost of Record-Keeping and Reporting Data to the Government: The Dodd bill contains requirements to report additional data to the SEC (or other designated agency). Costs here are associated with time spent to generate that data, as well as costs of reporting (EDGAR, etc). There are details here that are being left to be determined by the SEC, so it is early to be able to fill in the blanks in this category. Record-keeping in advisers that are currently unregistered will typically need to be improved, probably resulting in some incremental costs to systems and expended time.
5. Cost associated with Exams by the SEC: These can range from extensive on-site in-depth reviews, to a couple of hours work for the CCO to prepare a written response. Costs in this category vary accordingly.
6. Cost Associated with Changes in Service Providers: Some hedge fund advisers may find that they have to switch auditors or custodians in order to comply with the requirements of the law. Lots more expense in this category if that becomes necessary.
7. Lost Investors: The Dodd bill calls for the possible implementation of a higher net worth standard for eligible investors, obviously narrowing the universe of possible investors.
8. State Registration? The Dodd bill raises the suggestion that advisers that aren’t federally registered with the SEC will instead somehow be forced to register with their state. State regulations vary, but many roughly follow the federal registration, so we can assume for sake of discussion that costs are same as above.
Total tab for an individual hedge fund adviser?? As is evidenced above, that number is going to vary widely. Each adviser would have to assess their costs in each category, and add it up for their personal total.
Industry-wide total?? This depends on knowing a number that no one really has a handle on at this point: the number of advisers that are currently not registered that will need to be. Perhaps we will only know this number after the fact, as hedge funds are coaxed out of unregulated territory.
Link to the Dodd Bill: http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf
Allocation of Trades Continue to Vex Hedge Funds
The allocation of trades has always been an area of concern to hedge funds. The issue is whether a manager is breaching its fiduciary duties by favoring one fund or account over another. The reason this issue is so problematic is that it is so hard to define. For example, consider these scenarios:
*If a manager’s funds have different investment objectives or risk profiles - is there any reason for a manager to be concerned about trade allocations?
*What constitutes a “better investment” or “being favored” - is it always just a mathematical computation as to which investments provided a greater return?
*What are the manager’s obligations in terms of monitoring and documenting trade allocations? Particularly for funds that are frequent traders — does trade allocation need to be constantly monitored and documented?
*What if a manager decides not to make an investment for a particular account - is there any way in which that decision could be considered “favoring” that account? What circumstances would make it possible to prove that negative inference?
The trade allocation issue has always been one that the SEC has looked at in its exams, and it is also often the focus of litigation. Within the hedge fund industry, monitoring of the allocation of trades is becoming an increasingly sophisticated exercise, with a variety of forensic testing methods being utilized. Developing an appropriate system for monitoring is a key component of any good compliance program.
Hedge Fund Regulation Inches Forward
After a year of proposals, hedge fund regulation took a small leap forward during the past week here in the US with the introduction of truly viable legislation by Senator Dodd. In the EU, regulation is more or less at a standstill for the moment (but probably not for long).
In the meekly-titled 64 page bill called “Restoring American Financial Stability Act of 2010“, hedge funds are squarely in the mix of financial institutions that are being reined in. As expected, adviser registration requirements for advisers with over $100m under management are proposed. In addition, there is only a limited exemption for foreign advisers: they will only be exempt from registration if they have no place of business in the US, have fewer than 15 clients, have less than $25m in US client assets and do not hold themselves out to US investors as investment advisers (that’s a big “and”).
Dodd’s bill also calls for additional collection of information from hedge funds, including: level of assets, leverage, counterparty credit risk exposure, trading and investment positions, and types of assets held. The bill exempts venture capital firms and family offices from it entirely, but includes private equity firms to the extent that they will now have record-keeping responsibilities. The bill calls for “studies” of short-selling regulations, accredited investor standards (which in any case will be adjusted for inflation) and the feasibility of a self-regulatory organization for private funds. States will be required to pick up the supervision of hedge fund advisers that have under $100m in assets.
The “Volker Rule” is part of the Dodd bill and this directly impacts hedge funds to the extent that banks will be prohibited from “….proprietary trading, sponsoring and investing in hedge funds and and private equity funds, and from having certain financial relationship with those hedge fund or private equity funds for which they serve as investment adviser”. Divestitures that would follow if this rule is adopted would be massive, as in-house hedge funds have grown substantially over the last 10 years.
Separately, the fight in the EU over hedge fund regulation continues, with only a decision to “not decide” at the current time. It’s the UK vs. the rest of the EU on these proposed regulations, with the deep divide coming over the extent to which marketing by non-EU-based funds will be allowed in the EU (the so-called “passport”). Gordon Brown managed to score a victory of sorts by having a decision delayed for probably just a few months until June.
New Shorting Rules Will Affect Hedge Funds
New short selling rules are coming into effect both here in the US as well as abroad. They are squarely aimed at “speculators” and are in response to the myriad of crises that have affected markets in the last two years. More recently, the crisis in Greece is currently driving new proposals and bad publicity in the EU around short selling practices. While hedge funds are not the stated “targets” of these new rules, clearly many funds’ investment practices will be affected.
The SEC has now implemented the “alternate uptick rule” which puts in place a circuit breaker when there is excessive downward pressure on a stock. The aim is to reduce volatility and restore investor confidence. Any time a stock has dropped 10% in one day, the circuit breaker would immediately take effect and no shorting would be allowed unless the price is above the current national best bid. The SEC, while cognizant of the benefits of shorting in providing liquidity and pricing efficiency to the markets, believes that excessive downward price pressure is a destabilizing factor and erodes investor confidence. By in effect allowing long sellers to stand in front of the line ahead of short sellers, the SEC is responding to calls for short selling restrictions from investors and issuers alike which were heard loud and clear during the market crises of 2008-2009.
In the EU, the Committee of European Securities Regulators (CESR) has recommended that short sellers be required to report when they are short 0.2% or more to shares listed in the European Economic Area and when they change those positions by 0.1% or more. While there is some on-going debate about how public this reporting should be, we have already seen partial implementation of the rule in Germany and a similar rule already in place in the UK. Look for EU-wide adoption sometime in 2010, as well as additional regulations related to speculation in the CDS markets. Note that Hong Kong already has a rule in place requiring private disclosure to the regulator.
A more detailed description of the new US “alternative uptick” short-selling rule can be found on the SEC’s website at http://www.sec.gov/news/press/2010/2010-26.htm.
Hedge Funds and Client Info Protection: Massachusetts Stepping Up
Hedge funds with Massachusetts clients: take note! A new law is going into effect on March 1, 2010 which affects the way you secure your information.
Under the new law, entitled “STANDARDS FOR THE PROTECTION OF PERSONAL INFORMATION OF RESIDENTS OF THE COMMONWEALTH “, hedge funds will need to have written, comprehensive information security programs if they have “personal information” about a Massachusetts resident. Such personal information includes having: a social security number, drivers license or other government issued ID, financial account number or credit card number. Hedge funds are likely to have some or all of this information through the subscription process.
The law further calls for:
-Encryption of data over public networks
-Encryption of laptop and portable devices
-Having a designated employee in charge of data security
-Training employees on data security
-Developing security policies and overseeing their enforcement, including disciplining employees for infractions
-Selecting appropriate service providers (such as administrators) who can meet the requirements of the law, and so state in a written contract
- Taking steps to prevent physical access to data
-Annual review of program.
The above is a summary of the law. There are also specific requirements regarding computer systems.
We recommend a review of the law in light of your current program, particularly with regard to your administrator. The law can be found at http://www.mass.gov/Eoca/docs/idtheft/201CMR1700reg.pdf.
New SEC Custody Rule has Little Impact on Hedge Funds
In an effort to beef up surveillance of financial firms that hold custody of client assets, the SEC passed a final rule at the end of 2009 which amended the existing Custody Rule (Rule 206(4)-2 under the Investment Advisers Act of 1940). When the amendment was put out for public comment, the additional rules were written so as to be applicable to hedge funds. However, after over a thousand comment letters were received, the final rule was passed with a provision to except out most hedge funds.
In summary, the new amendments provide that a registered adviser having custody of client funds or securities be required to undergo an annual surprise examination by an independent public accountant to verify client assets; to have the qualified custodian send account statements directly to the clients; and unless client assets are maintained by an independent custodian (i.e., a custodian that is not the adviser itself or a related person), to obtain a report of internal controls relating to the custody of those assets from an independent public accountant that is registered with and subject to regular inspection by the Public Company Accounting Oversight Board (”PCAOB”).
Most hedge funds are exempt from these requirements as “pooled investment vehicles” that only meet the technical definition of “custody” because they can withdraw fees directly from client accounts. The Custody Rule calls for such pooled investment vehicles to be exempt from all requirements noted above if they obtain an annual audit from a PCAOB auditor within 120 days of their fiscal year end (180 days in the case of fund of funds) and distribute this audit to clients within that time frame. Assets still must be maintained at a qualified custodian. If the hedge fund does not meet these requirements, the adviser must indeed obtain an annual surprise examination and must have a reasonable basis, after due inquiry, for believing that the qualified custodian sends an account statement of the pooled investment vehicle to its investors. The only portion of the new rules that do apply to hedge funds is the requirement to obtain the internal control report if the assets are held with an affiliated custodian.
The amendments to the Custody Rule are highly complex and the SEC’s release about them runs over 120 pages. The release can be viewed at http://sec.gov/rules/final/2009/ia-2968.pdf. We expect that this blog post will be used as a summary only and look forward to answering any questions from clients.
Hedge Fund Compliance 2009: The Year in Review
For hedge funds, 2009 was certainly the year of anticipation. Anticipated new rules dominated the headlines and planning meetings. And it seemed like almost weekly, there were new scandals and additional revelations about the Madoff case that left everyone talking over the water cooler, trying to predict what the next shoe to drop would be.
Will registration requirements pass, and what will the size threshold and reporting requirements be? And that custody rule that drew so many comments throughout the year– will that be passed in 2010? 2009 saw the specter of anti-money laundering requirements for hedge funds, as well as the Form SH that was in effect for months before being dropped. The development of new EU requirements continued throughout the year and will do so into 2010 as those have yet to be finalized. The effect of the EU requirements on US fund advisers should not be under-estimated and is a topic that is being closely watched.
The year also saw tremendous developments in the litigation area and the bolstering of prosecutorial muscle. Starting the year with the Madoff scandal in full bloom, and moving into numerous new Ponzi schemes being uncovered, the year wound up with the Galleon insider trading case which featured the first use of wiretaps in such a case. Increasing integration of governmental arms at multiple levels, from the SEC to the States and other federal agencies, including prosecutors’ offices was a key advance in 2009.
So what should an average hedge fund adviser do to get ready for 2010? Easy… fasten your seatbelt, and either get, or stick with, a full-blown compliance program. Wishing you all the best for the new year!
Loading ...
