Regulation of Private Funds: Senator Reed and the Congressional Hearings
Judge Sotomayor’s Senate confirmation hearings may have overshadowed other proceedings on Capitol Hill last week, but members of the private equity community kept a watchful eye on what could turn out to have been landmark hearings on government regulation of private equity and hedge funds. Representatives from the private investment advisory community and institutional investors gathered to testify before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Development. The hearing was convened about a month after the Subcommittee’s chairman Senator Jack Reed (D – RI) introduced his own bill in the Senate, “The Private Fund Transparency Act of 2009.” Senator Reed’s proposed legislation would amend the Investment Advisers Act of 1940 to require investment advisers to private funds who manage assets in excess of $30 million to register with the Securities Exchange Commission. The SEC could in turn require registered investment advisers to submit records and reports to a federal systemic risk regulator.
Private Funds and the Investment Advisers Act
Before taking a look at last week’s hearings and Senator Reed’s bill, it’s instructive to place them in their historical context. The Supreme Court identified one of the fundamental purposes behind Congress’s passage of the Investment Advisers Act of 1940 as the substitution of “a philosophy of full disclosure for the philosophy of caveat emptor” in the securities industry. Under the Advisers Act and its implementing regulations, non-exempt investment advisers are required to register with the Securities Exchange Commission, and all advisers – registered and unregistered alike – are forbidden to engage in fraudulent or deceptive practices.
Hedge funds (and private equity funds) are typically structured as limited partnerships, with the general partner managing the fund for a fixed fee and a percentage of the fund’s gross profits. Although hedge fund general partners meet the statutory definition of “investment advisor,” they generally qualify for the “private adviser” exemption from SEC registration under §203(b)(3) of the Advisers Act. The private adviser exemption is available to any adviser that has fewer than 15 clients and does not generally hold itself out to the public as an investment adviser. With respect to hedge funds organized as limited partnerships, the SEC historically interpreted the term “client” in §203(b)(3) to refer to the limited partnership itself rather than to the investors constituting its limited partners.
In 1998, Long-Term Capital Management, a Connecticut-based hedge fund that managed over $125 billion in assets during its heyday, imploded. With many of the country’s major financial institutions at risk because of their credit exposure to Long-Term, the Federal Reserve Bank of New York stepped in to orchestrate the fund’s financial resurrection to avert a national financial crisis. Shortly thereafter, a joint working group of the country’s leading financial regulators embarked on a comprehensive study of the U.S. hedge fund industry.
Prompted by the working group’s findings, the Securities Exchange Commission adopted the so-called “Hedge Fund Rule” in 2004. The Hedge Fund Rule required most hedge fund advisers to register with the SEC if the funds they managed had more than 15 “shareholders, limited partners, members, or beneficiaries.” In other words, the SEC reinterpreted the definition of “client” under the Advisers Act so that general partners of hedge funds had to “pierce the veil” of their fund to reach its beneficial owners in order to determine how many clients they advised. The D.C. Circuit Court of Appeals vacated the “Hedge Fund Rule” in 2006, dismissing it as “arbitrary.” Consequently, many general partners of hedge funds (and other private funds) still rely on §203(b)(3) to claim an exemption from registration under the Advisers Act.
Senator Reed’s Proposal for Regulating Private Funds
The Private Fund Transparency Act of 2009 (S. 1276), introduced by Senator Reed in June, would amend the Advisers Act to require investment advisers to private funds who manage assets in excess of $30 million to register with the SEC. The text of the bill restricts the private adviser exemption under §203(b)(3) to apply only to a narrowly defined group of “foreign private advisers.” Under Senator Reed’s proposal, all registered private fund advisers – including advisers to hedge funds, private equity funds, and venture capital firms – would be subject to the Advisers Act’s existing regulations regarding disclosures to the SEC, maintenance of books and records, custody of fund assets, compliance policies and procedures, advertising, and the examination of financial and other records by the SEC. (Last week, the Obama administration proposed parallel legislation that would create a new class of “private funds” subject to registration under the Investment Company Act of 1940 and require advisers to private funds to register with the SEC under the Advisers Act).
In a recent interview with the Wall Street Journal, Senator Reed emphasized the need for transparency and government oversight to ensure what he called “fair dealing with customers.” Andrew J. Donohue, Director of Investment Management for the SEC, advised the Senate Subcommittee that registration of investment advisers with the SEC was essential to giving teeth to the Advisers Act’s anti-fraud provisions by providing the SEC “an opportunity to determine facts that most investors in private funds cannot discern for themselves,” and speculated that registration might deter unscrupulous advisers from committing fraud. Mr. Donohue also called for (and Senator Reed’s proposed legislation contemplates) granting additional rulemaking authority to the SEC to enforce its broadened jurisdiction under the Advisers Act.
In addition to protecting investors, Senator Reed described the other goal of his bill as devising a regulatory regime capable of aggregating information about various financial industries “in a meaningful way so that systemic regulators could get a sense if there is a possibility of risk in a particular market.” Back in April, we wrote about Treasury Secretary Geithner’s outline for a reporting system in which the SEC would work in tandem with a systemic risk regulator to ferret out privately managed funds deemed to pose a systemic risk to U.S. financial markets. The Private Fund Transparency Act specifically authorizes the SEC to require any registered investment advisor to “maintain such records and submit such reports as are necessary or appropriate in the public interest of the supervision of a systemic risk by any Federal department or agency.” In a press release posted on the Treasury Department’s website today, Mr. Geithner announced: “There exists today a national mandate, not seen in years, to reform our outdated and ineffective regulatory system.”
Private Equity’s Response
Lobbyists and representatives from the private equity industry have been clamoring that the private equity industry is not too big to fail, yet have been conciliatory with regard to oversight. Perhaps this is not surprising. A number of private equity’s largest players, including the Carlyle Group, the Blackstone Group, and Kohlberg, Kravis, Roberts & Company, are already registered with the SEC. Mark Tresnowski, general counsel of private equity firm Madison Dearborn Partners, who spoke on behalf of the Private Equity Council, warned the Senate Subcommittee that although the private equity community supported registration of advisers in principle, any reporting and other requirements should be tailored to the type and size of the firm so as to reduce the inevitable increased administrative costs for funds. He concluded: “Private equity contains none of these systemic risk factors and thus should pose little concern for policy makers seeking to develop a new regime to guard against catastrophic, cascading financial shocks.” Private Equity Council President Douglas Lowenstein echoed Tresnowski’s opinions in testimony before the House’s Financial Services Committee two days later.
This week, the Obama administration followed up last week’s hearings by sending a plan for a systemic risk regulator to Congress. The proposal would establish a Financial Services Oversight Council comprising bank and securities regulators that would be tasked with collecting information on systemic risk and would give the Federal Reserve authority to act as a systemic risk regulator. Both Senator Reed’s and the Obama administration’s proposals for registering private investment funds and/or their advisers would grant widespread authority to the SEC to determine what information should be shared with a systemic risk regulator.
One has to wonder whether the private equity industry’s tactic of conceding on SEC oversight while trying to persuade federal legislators that its business model does not pose a systemic threat to the U.S. financial markets will undermine its longer term strategic interests. Once a substantial portion of the private equity industry falls under the umbrella of the SEC’s regulatory authority, there may be little lobbyists and other industry representatives can do to persuade the systemic risk regulator – be it the Federal Reserve or another government agency – that private equity funds do not pose system-wide financial risks. At that point, leveraged buyout firms may have lost their negotiating leverage.
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