The Securities and Exchange Commission ("SEC") Chairman has released the much anticipated SEC Staff Report entitled "Implications of the Growth of Hedge Funds". The Report follows an investigation into the operations and practices of the largely unregulated US hedge fund industry conducted by the Staff of the SEC. The Report is not a policy statement of the SEC itself. Rather, it is an attempt by SEC Staff to summarize their concerns arising from the rapid and significant growth of the industry. More importantly, the Report signifies a marked shift in SEC Staff’s approach to the hedge fund industry and could be the first step towards the SEC assuming a more active role in regulating the industry.
In the Report, SEC Staff identified a number of areas of concern including the following:
• the SEC’s lack of information on and understanding of hedge funds and their advisers’ activities;
• the lack of prescribed and uniform disclosure by hedge fund advisers;
• valuation and other conflicts of interest issues;
• the retailization of hedge funds (mostly through registered funds of funds); and
• the recent increase in the number of enforcement actions taken against hedge fund advisers in the United States.
Staff Recommendations For Registration
SEC Chairman William H. Donaldson has referred to the recommendations as an attempt to introduce a culture of compliance in the hedge fund industry, which would benefit both industry members and investors.
SEC Staff’s primary recommendation is to require most hedge fund advisers to register with the SEC as investment advisers under the Investment Advisers Act of 1940. Currently, hedge fund advisers that advise fewer than 15 clients are exempt from registration. Staff has recommended that hedge fund advisers be required to look through any funds under their management and count each investor in each fund as a separate client. Staff has also proposed that hedge fund advisers managing assets in excess of a certain minimum dollar threshold be required to register.
In the opinion of SEC Staff, the registration requirement would not be intrusive since registration would not necessarily impede the advisers’ ability to implement certain investment strategies, such as using leverage or derivatives or short selling. Staff indicated that based on the industry statistics, it is estimated that about one quarter of hedge fund managers are already registered as investment advisers with either state authorities or the SEC, and that almost two-thirds of the 100 largest hedge funds are already registered with the Commodity Futures Trading Commission (the "CFTC"). Ironically, the CFTC has recently proposed exempting some hedge funds from registration. In the Report, Staff has also dismissed hedge fund advisers’ concerns that registration would lead to public disclosure of proprietary trading strategies and portfolio positions or result in the public identification of hedge fund investors.
SEC Staff argues that the proposed registration regime and the ensuing SEC oversight would allow the SEC to gather more accurate information on the industry, conduct timely compliance investigations of advisers and play a more proactive role in policy development and thus, fraud prevention. The SEC Chairman has noted that the registration requirement would, in practice, introduce higher investment requirements and limit expansion of hedge funds in the retail market.
In the opinion of SEC Staff, the registration requirement would bring a degree of transparency to the industry and would enable the SEC to require hedge fund advisers to disclose information about issues important to investors, such as conflicts arising from side-by-side management of hedge funds and other client accounts and the relationships between hedge fund advisers and prime brokers.
In making these recommendations, the SEC Staff was mindful of the increasing strain on SEC resources and has asked the Commissioners to consider whether the benefits would outweigh the burdens of registration.
Other Recommendations Made by SEC Staff
- Hedge fund advisers should be required to file with the SEC a hedge fund disclosure statement, including disclosure on conflicts of interest, risk management measures, valuation procedures and fee structure of the fund, and deliver the disclosure statement to investors.
- The prohibition on general solicitation or advertising in offerings by hedge funds that are sold exclusively to highly sophisticated investors should be eliminated.
- Prime brokers’ capital introduction practices should be more closely monitored.
- The hedge fund industry should be encouraged to embrace existing "best practices" and refine and improve these best practices to supplement current conflict management practices.
- Increasing investor education regarding hedge funds, their investment strategies and their operations should be a priority for the regulatory agencies.
- All registered investment companies that invest their assets in hedge funds, including registered funds of hedge funds, should be required to adopt valuation procedures that are consistent with the provisions of the Investment Company Act.
Although the Report does not yet introduce changes, it is expected to face tough review from the five member panel of SEC Commissioners, the industry and the public. To date, the Report has received mixed reviews. While the North American Securities Administrators Association has welcomed the Report and encouraged the Commissioners to adopt the necessary changes to protect investors, the Managed Funds Association has stated that the registration requirement would place a significant and unnecessary burden on the SEC as well as investors. The recommendations in the Report require the support of a majority of the Commissioners in order to be adopted. It is anticipated that it will take at least two months for the Commissioners to complete their review of the recommendations.
The Commissioners’ progress in reviewing the Report will be closely monitored in Canada by both the Canadian hedge fund industry and the securities regulators. Any changes in the regulation of hedge funds in the United States could have an impact on the Canadian hedge funds that already have US operations or are planning to expand into the United States. With respect to the Canadian securities regulators, it is believed that they will consider the Commissioners’ response to these recommendations when assessing what approach to take in Canada. As of the date of this bulletin, none of the Canadian securities regulators have commented on the Report.
The foregoing provides only an overview. Readers are cautioned against making any decisions based on this material alone. Rather, a qualified lawyer should be consulted.
© Copyright 2003 McMillan Binch LLP