Category: Private Investment Funds

More on the Private Fund Investment Advisers Registration Act of 2009

Capitol_dome

There are three and half bills in Congress for regulating private investment funds. The Hedge Fund Adviser Registration Act of 2009, the Hedge Fund Transparency Act of 2009 and the Private Fund Transparency Act of 2009 are all sitting in committee. The half is the proposal from the Obama administration: Private Fund Investment Advisers Registration Act of 2009. The Obama bill has not yet been submitted.

The National Venture Capital Association has been lobbying hard (or at least effectively) to get some changes in the bill before it is submitted. There is now new language in the bill that reads:

(l) EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.—The Commission shall identify and define the term ‘venture capital fund’ and shall provide an adviser to such a fund an exemption from the registration requirements under this section. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.

Of course that still defers the very difficult task of defining a “venture capital fund” from the various types of private investment funds.

In a statement from Mark G. Heesen, president of the National Venture Capital Association:

“This proposal recognizes that venture capital firms do not pose systemic financial risk and that requiring them to register under the Advisers Act would place an undue burden on the venture industry and the entrepreneurial community. The venture capital industry supports a level of transparency which gives policy makers ongoing comfort in assessing risk.”

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Corporate and Financial Institution Compensation Fairness Act of 2009

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I had largely ignored the Corporate and Financial Institution Compensation Fairness Act of 2009 (H. R. 3269) thinking it was limited to public companies and banks. I was surprised to find that it also sweeps up investment advisers, and therefore private investment funds, with assets greater than $1 billion.

The bill does focus mostly on public companies and gives shareholders a “say on pay.” But I just noticed that the bill would have an impact on private investment funds.

Section 4, Enhanced Compensation Structure Reporting to Reduce Perverse Incentives, provides

“the appropriate Federal regulators jointly shall prescribe regulations to require each covered financial institution to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements offered by such covered financial institutions …”

The definition of covered financial institution includes: “an investment advisor, as such term is defined in section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)(11))”. There is a later exemption for covered financial institutions with assets of less than $1,000,000,000.

The bill would empower federal regulators to:

“prescribe regulations that prohibit any incentive-based payment arrangement, or any feature of any such arrangement, that the regulators determine encourages inappropriate risks by covered financial institutions that–

  1. could threaten the safety and soundness of covered financial institutions; or
  2. could have serious adverse effects on economic conditions or financial stability.”

It seems like Congress wants to be able to limit the compensation for investment advisers, hedge fund managers, the managers of other private investment funds.

The bill was passed by the House on July 31. The Senate has not yet taken it into consideration.

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Image is from Wikimedia Commons: US Capitol Dome Jan 2006.

Pension Security Act of 2009 and its Effect on Private Investment Funds

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I missed the introduction of the Pension Security Act. Rep Michael Castle introduced the bills in January and it was referred to the Committee on Education and Labor. It’s a short bill, but would have a big effect on the disclosure of investments in private investment funds.

The bill revises a section of the Employee Retirement Income Security Act (ERISA) and require of disclosure of which hedge funds the defined benefit pension plan has invested and the dollar amount of the investment.

The bill had a broad definition of “hedge fund”:

means an unregistered investment pool permitted under sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1), (7)) and section 4(2) of the Securities Act of 1933 (15 U.S.C. 77d(2)) and Rule 506 of Regulation D of the Securities and Exchange Commission (17 CFR 230.506).

The bill would require defined benefit pension plans on their annual financial statement to identify on a separate schedule, each “hedge fund in which amounts held for investment under the plan are invested as of the end of the plan year covered by the annual report and the amount so invested in such hedge fund.”

The Secretary of Labor,  in consultation with the Securities and Exchange Commission, would be charged with issuing initial regulations within one year.

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AIMA Warns of Global Impact of EU AIFM Directive

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The Alternative Investment Management Association has warned that the European Commission’s draft directive on Alternative Investment Fund Managers would negatively affect fund managers and investors around the world if enacted into European law.

The Directive applies primarily to any Alternative Investment Fund Managers which is established in an EU Member State and which provides management and administration services to one or more alternative investment funds. However, it will also apply to the marketing of a fund within the EU by Alternative Investment Fund Managers which are established outside the EU.

Marketing Conditions

There are five conditions that a non EU registered fund manager must meet to be able to market the alternative investment fund in the EU:

  • Its home country must have prudential regulation and ongoing supervision which is “equivalent” to the Directive’s provisions
  • Its home country allows effective market access to EU fund managers which is comparable to that granted by the EU to fund managers from that country
  • Its home country has a cooperation agreement with EU regulators for monitoring the potential implications of the activities of the Third Country Fund Manager for the stability of systemically relevant financial institutions and the orderly functioning of markets
  • Its home country has signed an agreement with EU regulators to allow the sharing of  information on tax matters
  • The fund must provide EU regulators with the identities of significant owners

Satisfying the Conditions

Unfortunately for fund managers, four out of the five requirements require their home country to act. If the EU effectively locks out funds managed by non-EU fund managers, countries may reciprocate and lock out funds managed by EU managers from their markets.

If the Directive is adopted in its current form, fund managers may need to open an EU office and subject themselves to the EU and member state regulations.

Status

The Directive is merely at the start of the EU’s legislative process and it is likely to be revised before the Directive comes into force.

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Placement Agents Fight Bans

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Placement agent bans were put in place at the New York State Common Retirement Fund and the New Mexico State Investment Council because of the pay-to-play scandals at those pension funds. Now the SEC has proposed a ban on using placement agents when seeking capital investments from public pension funds.

A coalition of placement agents is urging the SEC to pull the plug on its proposed rule, convinced it could put some of them out of business. Placement agents are accusing the Securities and Exchange Commission of regulatory overkill, saying the proposal would indiscriminately hammer both good and bad firms.

The coalition is offering an alternative proposal:

Placement agents would be barred from making political contributions to anyone in the decision-making chain of command for public pension fund investments. The placement agent would disclose its fee arrangement with the fund’s general partner to any potential limited investment partners. Placement agents must be registered with the SEC or the Financial Industry Regulatory Authority.

There are also a few comments already submitted on the SEC’s Proposed Rule for Political Contributions by Certain Investment Advisers.  Ted Carroll’s comment is short and straight to the point:

“Please stop all this nonsense. Placement agents provide a valuable service to small and midsized investment firms and 99.99% are honest diligent people. Its offensive to see the many large political donors involved in the recent pay to play schemes get to pay fines and adopt hollow policies to avoid real prosecution. Catch and punish the guilty, leave the innocent alone.”

The comment from Claude R. Parenteau points out that the actions that precipitated the SEC proposal were already illegal activities under current regulations.

The comments also point out that the restriction could disadvantage smaller investment advisers who use placement agents to outsource marketing and sales because they can’t afford the overhead of having their own full-time marketing and sales staff.

    References:

    Indemnification for Investment Professionals by Their Funds

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    A recent case decided some issues relating to the indemnification of private equity and venture capital professionals by their affiliated funds in connection with their service as directors and officers of their portfolio companies. Stockman v. Heartland Industrial Partners, L.P., (July 14, 2009), Delaware Chancery Court.

    David A. Stockman and J. Michael Stepp were investment professionals at Heartland Industrial Partners, L.P. (“Heartland”). They also served as officers and directors of Collins & Aikman Corporation (“C&A”), and joined C&A at the direction of Heartland.

    C&A got itself into some accounting trouble. That also got Stockman and Stepp involved in civil and criminal proceedings in connection with their roles at C&A. Stockman and Stepp sought advancement of legal fees and indemnification from C&A, and when C&A’s insurance was exhausted, they sought advancement of legal fees and indemnification from Heartland. Heartland refused to advance legal expenses to Stockman or Stepp unless they agreed to additional conditions not written in the Partnership Agreement.

    Stockman and Stepp argued that both advancement and indemnification to them are mandatory under Heartland’s Partnership Agreement.

    Heartland took the position that the Partnership Agreement granted it the discretion to impose additional conditions beacuse of the requirement in the advancement provision that Heartland’s General Partner give prior approval. Heartland contended that advancement is not mandatory when its General Partner has refused to provide written approval. Also, Heartland argued that indemnification is not mandatory because Stockman and Stepp must prove that the conduct giving rise to the underlying dismissed criminal action met three requirements set forth in the Partnership Agreement. Heartland asserted that it is Stockman and Stepp’s burden to demonstrate that they i) did not breach their duties to the partnership; ii) did not knowingly violate applicable law; and iii) did not act with scienter.

    The court found in favor of Stockman and Stepp on both their advancement and indemnification claims “because the plain language of the Partnership Agreement does not unambiguously support Heartland’s reading of that document.” To the extent there is any ambiguity in the Partnership Agreement regarding advancement, that ambiguity must be resolved against the partnership in favor of the officers.

    The Partnership Agreement contains a broad indemnification provision:

    To the fullest extent permitted by law, the Partnership agrees to indemnify and save harmless each of the Indemnitees from and against any and all claims, liabilities, damages, losses, costs and expenses . . . of any nature whatsoever, known or unknown, liquidated or unliquidated, that are incurred by any Indemnitee and or to which such Indemnitee may be subject by reason of its activities on behalf of the Partnership or in furtherance of the interest of the Partnership or otherwise arising out of or in connection with the affairs of the Partnership, its Portfolio Companies or any Alternative Vehicle . . . provided, that: (i) an Indemnitee shall be entitled to indemnification hereunder only to the extent that such Indemnitee’s conduct (A) was in or was not opposed to the best interests of the Partnership, (B) in the case of a criminal action or proceeding, the Indemnitee had no reasonable cause to believe his conduct was unlawful, or (C) did not constitute fraud, bad faith, willful misconduct, gross negligence, a violation of applicable securities laws or any material breach of the Agreement or the Advisory Agreement . . .

    and advancement rights under certain conditions:

    Expenses reasonably incurred by an Indemnitee in defense or settlement of any claim that may be subject to a right of indemnification hereunder shall be advanced by the Partnership prior to the final disposition thereof upon receipt of an undertaking by or on behalf of the Indemnitee to repay such amount to the extent that it shall be determined ultimately that such Indemnitee is not entitled to be indemnified hereunder. No advances shall be made by the Partnership under this Section 4.4(b)(i) without the prior written approval of the General Partner or (ii) in connection with an action brought against an Indemnitee by a Majority in Interest of the Limited Partners.

    So, advancement of expenses to Heartland Indemnitees is mandatory under the Partnership Agreement, subject to the requirement of prior written approval from the General Partner.

    You may want to check the indemnification and advancement provisions of your partnership agreements to see how well they work on the basis of this decision.

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    Regulating Private Investment Funds

    Capital_BuildingLast week the Subcommittee on Securities, Insurance, and Investment of the United States Senate Committee on Banking, Housing and Urban Affairs held a hearing on regulating private investment funds. [You can see an archive of the hearing.] The video shows lots of empty Senator chairs at the hearing.

    Senator Reed pushed his Private Fund Transparency Act. Senator Bunning sees some need for more disclosure, but is skeptical that regulation would do much.

    Mr. Donohue’s statement gives a great summary of the history of the regulatory approaches to private investment funds and a summary of the current exemption available to private investment funds.

    The questions from the Senators also provided some interesting insight of the legislators and SEC. Mr. Donahue’s pitch for regulation was that the Investment Advisers Act was put in place to regulate people who manage other people’s money. Private fund advisers indirectly manage other people’s money.  He does not like the idea of putting private funds under the Investment Company Act. Senator Reed pointed out that bringing private funds under the SEC registration umbrella would require additional resources and technology.

    Senator Bunning cut into Mr. Donohue, wanting to know who in the SEC is “smart enough.” The Senator was highly critical of the SEC.

    Senator Bayh focused on the international issues and the EU’s Directive on Alternative Investment Fund Managers. He also wondered if over-regulation could lead to forum shopping by fund managers.

    Mr. Singh pushed for “smart regulatory framework.” He pointed out the MFA’s Sound Practices for Hedge Fund Managers (.pdf).

    Mr. Chanos pitched the idea of having a special Private Investment Company law specifically tailored for SEC regulation of private investment funds. (In my view, the best approach.)

    Mr. Loy gave the view of venture capital funds and how they operate differently than hedge funds. He pointed out that venture capital funds do not provide systemic risk.  Senator Bunning showed a lack of understanding of venture capital.

    Mr. Tresnowski presented on behalf of The Private Equity Council and showed the differences between private equity and hedge funds. Senator Bunning also showed a lack of understanding of private equity.

    Mr. Bookstabber focused on systemic risk.

    Mr. Dear gave the viewpoint of an investor in private funds.  He also pointed out the superior returns they have experienced with private investment funds.

    SEC to Consider Pay to Play Rule for Investment Advisers

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    At the SEC open meeting on Wednesday July 22, the Commission will consider whether to propose a rule to address “pay to play” practices by investment advisers. The proposal is designed, among other things, to prohibit advisers from seeking to influence the award of advisory contracts by public entities through political contributions to or for those officials who are in a position to influence the awards.

    You can watch the meeting through the SEC Open Meetings Webcast, starting at 2:00 pm (EDT).

    Private Fund Investment Advisers Registration Act of 2009

    treasury

    The Department of Treasury released its proposed legislation in increase the regulatory oversight on private investment funds: Private Fund Investment Advisers Registration Act of 2009. The Administration’s legislation would require that all investment advisers with more than $30 million of assets under management to register with the SEC.

    This is presumably the Obama plan and becomes the fourth piece of legislation proposed this year to regulate private investment funds. It joins the Hedge Fund Adviser Registration Act of 2009, the Hedge Fund Transparency Act of 2009 and the Private Fund Transparency Act of 2009.

    Disclosures to the SEC:

    The legislation would grant broad power to the SEC to require the disclosure of information about the fund “as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council, . . ” This includes:

    • amount of assets under management
    • use of leverage (including off-balance sheet leverage)
    • counterparty credit risk exposures
    • trading and investment positions, and
    • trading practices

    Of course is also requires the private fund to allow examinations by the SEC.

    Disclosures to Investors:

    The legislation would grant broad power to the SEC about the disclosures that need to made by private funds to investors, prospective investors, counterparties, and creditors, of any private fund.  The SEC would be able to require disclosure “as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.”

    Defining Clients (updated)

    The legislation would all the SEC to “ascribe different meanings to terms (including the term ‘client’) used in different sections” of the Investment Advisers Act. This is an attempt to address the demise of the Hedge Fund Rule and allow the SEC to define the investors in private investment funds as “clients” of the fund manager. The courts had ruled that the SEC overstepped their authority when they tried this definition on their own.

    I am not a big fan of this approach. The Act would better amending 203(b)(3) to exclude the new term “private fund” from the 15 client rule exemption. I don’t like the idea that a limited partner investor in a private fund could be deemed a “client” of the adviser in addition to the fund itself.

    CFTC

    The legislation calls for the SEC and CFTC to establish joint rules for investment advisers who are already subject to the CFTC and would now also be regulated by the SEC.

    Summary

    This legislation is very similar to the Private Fund Transparency Act of 2009 proposed by Senator Reed. It pushed most of the decision-making onto the SEC for the Commission to come up with the disclosure requirements. At this point, it is not clear which of the competing acts will end up becoming law, if any.

    References:

    Special Report on Sovereign Wealth Funds

    Pensions and Investments

    Pensions & Investments published a Special Report on Sovereign Wealth Funds. The report is based on a survey conducted in April by the Oxford University Center for Employment, Work and Finance: Oxford SWF Project.

    Sovereign wealth funds are perceived to be shrouded in mystery because, like many private investment funds, they do not publicly report their investment activity. One item that attracts attention is the size of these funds. They are collectively a pool of capital estimated to be somewhere between about three trillion to nearly seven trillion dollars. The largest individual fund is believed to have assets of over $600 billion.

    The special report was based on interviews of investment managers who routinely work with sovereign investment funds, not directly with officers of the funds themselves. So, the information is second hand.

    The report predicts a movement away from U.S. Treasuries and towards equities and real estate.

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