On March 26, 2009, Secretary of the Treasury Timothy Geithner appeared in front of the Committee on Financial Services of the U.S. House of Representatives to introduce his proposal for comprehensive financial regulatory reform. In his testimony Secretary Geithner made it clear that he's not looking for modest repairs—he's looking for "new rules of the game". The proposed regulatory reform, which is still in the early stages of development and will require Congressional approval, reflects a range of complex and consequential policy choices that directly impact private investment funds and their advisers.
Going beyond the recent Congressional proposals to regulate private investment funds and their advisers discussed in our January 29, 2009, February 3, 2009 and March 20, 2009 Client Alerts, one aspect of today's proposed reform could subject these funds and advisers to capital and risk management requirements similar to those currently imposed on banks and broker-dealers.
With his testimony today focusing on the first of six elements in his comprehensive plan—a framework for systemic risk—Secretary Geithner proposed creating a single, independent regulator with responsibility over systemically important firms (regardless of whether those firms own a depository institution) to account for the risk that the distress or failure of such a firm could impose on the financial system and the economy.
The Treasury Department intends to work with Congress to enact legislation that defines the characteristics of covered firms; sets objectives and principles for their oversight; and assigns responsibility for regulating these firms. In identifying systemically important firms, the Treasury Department is focusing on what companies do, not the form they take. The proposed characteristics of covered firms include:
- the financial system's interdependence with the firm;
- the firm's size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding; and
- the firm's importance as a source of credit for households, businesses, and governments and as a source of liquidity for the financial system.
However, Secretary Geithner clearly intends to include in the definition of those covered firms all private investment funds that have the potential to pose a threat to financial stability. Firms identified as being systemically important would be subject to capital requirements sufficiently robust to be effective in a wide range of deeply adverse economic scenarios, as well as to stringent liquidity, counterparty and credit risk management requirements. The systemic risk regulator would be able to force protective actions as regulatory capital levels decline, similar to the powers of the FDIC with respect to its covered agencies.
In addition, the framework for systemic risk will focus on the regulation of all private investment funds and their advisers, requiring the following:
- Registration of Certain Investment Funds—All advisers to all private investment funds (including, hedge funds, private equity funds, venture capital funds and other private pools of capital) with assets under management over a certain threshold would be required to register with the SEC.
- Investor and Counterparty Disclosure—All such funds advised by an SEC-registered investment adviser would be subject to investor and counterparty disclosure requirements and regulatory reporting requirements.
- Reporting of Information Necessary to Assess Threats to Financial Stability—The regulatory reporting requirements for such funds would require reporting, on a confidential basis, information necessary to assess whether the fund or fund family is so large or highly leveraged that it poses a threat to financial stability.
- Sharing of Reports With Systemic Risk Regulator—The SEC would share the reports that it receives from the funds with the new systemic risk regulator, which would then determine whether any funds could pose a systemic threat.
- Imposition of Capital and Risk Management Requirements—If the new systemic risk regulator determines a fund to pose a systemic threat, then the new systemic risk regulator could impose on such fund capital and risk management requirements, including liquidity, counterparty and credit risk management requirements.
The Treasury Department also intends to launch a new, three-pronged initiative to address prudential supervision, tax havens, and money laundering issues in weakly-regulated jurisdictions. Anticipating that there might be an exodus to less regulated jurisdictions, the Treasury Department intends to ensure that global standards for financial regulation are consistent with the high standards to be implemented in the United States.
Bracewell & Giuliani is committed to keeping clients and friends immediately apprised of new legislative proposals as the 1st session of the 111th Congress and the Obama Administration show that sweeping reform of the financial services industry, and private investment funds and their general partners and investment managers, will be at the center of the agenda.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.