A final get set go for Fund Advisers?
The economic downturn of 2007-2008 has instilled, with greater force, the need for sustained economic growth globally through employment of conservative business practices and adoption of risk mitigating policies and regulation. Amidst allegations of a ‘shadowy’ character to the financial system of the hedge fund industry, the US Senate Committee on Banking proposed a bill in April this year, to introduce mandatory registration for certain private fund advisers exempt earlier under the Investment Advisers Act, 1940, while implementing certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act enacted this year. The officials believe that this step will enable them to monitor the systemic risk posed by private funds, as an asset class, to the financial system.
The industry was faced with regulation by the Securities and Exchange Commission of the US (“SEC”) way back in 2004, ever since SEC introduced the famous, rather infamous regulation imposing reporting and disclosure requirements in relation to “hedge” funds. In common parlance, “hedge” funds are investment pools of sophisticated investors which function on the principle of ‘high risk high returns’ but may not employ hedging techniques at all. Hence, the term “hedge” fund is a misnomer. Aggrieved by the unwelcome development which invaded the much sought-after privacy in operations, some of the “hedge” fund managers led by Mr. Philip Goldstein challenged this SEC regulation before the Federal Appeal Court, District of Columbia arguing that the SEC had exceeded its authority in introducing an amendment to the Investment Advisers Act, 1940.
Many investment advisers to private funds currently rely on the “private adviser” exemption from registration under the Investment Advisers Act for advisers with fewer than fifteen clients – where the term “clients” is defined in a way that allows each fund to be counted as a single client without lifting the veil to consider the underlying investors. In 2006, the Appeal Court invalidated SEC’s regulation in question, as it concluded that the Investment Advisers Act exempted investment companies with less than 100 ‘investors’ from government regulation, while the questioned regulation determined that investment companies with fifteen or more ‘investors’ would trigger registration under the Investment Advisers Act. The Appeal Court held that the SEC had erred in treating all ‘investors’ in each fund equivalent to as many “clients” of the investment adviser as against treating one fund entity as a single “client”, as interpreted earlier. However, the Appeal Court directed the SEC to frame appropriate rules in the context, such that the rules pass judicial scrutiny.
In the background of the Appeal Court order and the pressing need to regulate private funds (hedge funds as popularly known) in some manner, the Dodd-Frank Act paved way for the enactment of the Private Funds Investment Advisers Registration Act of 2010. The Registration Act has eliminated the earlier “private adviser” exemption and replaced it with limited exemptions for certain categories of advisers. First of those exempted classes are advisers of venture capital funds and family offices which enjoyed an exemption earlier too. The SEC has separately laid down criteria for advisers of venture capital funds and family offices in order to qualify for the exemption. The second category consists of “foreign private advisers”, that is to say any investment adviser that (i) has no place of business in the US; (ii) has fewer than 15 clients who are domiciled in or residents of the US; (iii) does not manage, aggregate assets under management attributable to clients in the US and investors in the US in private funds, above US$25 mn or a prescribed higher amount; and (iv) does not hold itself out as an investment adviser to the public in the US. As a general rule, an adviser relying on the foreign private adviser exemption is permitted to have advisory relationships with a limited number of qualified US investors. On November 19, 2010, the SEC announced new rules to define terms like “clients”, “investors” and “place of business” used (but not defined) in the Registration Act provision, embodying the foreign private adviser exemption. To list a few consequences, an adviser to a master fund in a master-feeder arrangement would have to treat holders of the securities of any feeder fund, formed or operated for the purpose of investing in the master fund, as investors, as also take into account the ultimate underlying holders of the fund’s securities.
To add to its efforts to bulk up private funds regulation, the SEC has also proposed rules to implement the amendments made to the Investment Advisers Act, with regard to registration of investment advisers to private funds, having principal office in the US and managing assets worth at least US$150 mn in the US, with the SEC. Under this provision, such an adviser could advise an unlimited number of private funds, provided that the aggregate value of private fund assets managed by the adviser is less than US$150 mn. The proposed rules also require such advisers to provide information regarding their assets, investors, type of services provided to the fund and significant intermediaries and market players involved, whom the SEC has termed as “gatekeepers” and also make it mandatory for advisers not crossing the threshold to provide certain information to the SEC from time to time. Besides, the rules provide for transition of regulation of mid-sized advisers i.e., advisers registered as such in the state in which they maintain their principal office and place of business and having assets worth a minimum of US$25 mn and a maximum of US$100 mn under management, from the SEC to the respective state securities authorities as envisaged by the Dodd-Frank Act.
Reports stating that “hedge” funds will come under the net of these new rules are to that extent misleading since the financial reforms law, the Dodd-Frank Act, has brought the entire asset class of private funds (which includes private equity funds but excludes venture capital funds) under the scanner. As a consequence of this distorted understanding, one will notice that many large hedge funds as against private equity firms have already registered with the SEC after the registration requirement began looming over the industry in 2004.
The rules proposed by SEC have been thrown open to the public for comments for a period of 45 days, after which the rules will be finalized and notified. This period will witness some of the most important debates on the concerns and perspectives of various market players in the industry and later perhaps, another round of challenge in the courts. The wait will particularly be nerve-racking for foreign advisers accessing US capital markets. In view of the potential cumbersome registration requirement and encroachment on operational privacy, it is time for those engaged in typical master-feeder structures in the Indian foreign investment scenario, to increase preparedness, voice opinions and reformulate business strategies.