Under the Obama plan, all advisers to private pools of capital, including hedge funds, private equity funds and venture capital funds, would be required to register with the SEC under the Investment Advisers Act of 1940. There would be an exception for advisers whose assets under management did not exceed “some modest threshold.” All registered private investment funds would be subject to
Reporting information on the funds they manage that is sufficient to assess whether any fund poses a threat to financial stability
Recordkeeping requirements,
Requirements regarding disclosures to investors, creditors and counterparties and
Regulatory reporting requirements
Regular, periodic examinations by the SEC to monitor compliance with these requirements
Confidential reporting on assets under management, borrowings, off-balance sheet exposures, and other information deemed necessary to assess whether a fund or group of related funds is so large, highly leveraged, or interconnected that it poses a threat to financial stability.
The Report found the United States is generally open to foreign investment, except for sector-specific restrictions. The banking, agriculture, transportation, natural resources and energy, communications, and defense sectors have federal laws that apply to foreign investment specifically. These sectors have laws that contain provisions that either restrict the level of foreign investment, limit the use of a foreign-owned asset, or at least require approval or disclosure of any foreign investments.
In addition to these specific limitations, there is the broad power under the Defense Production Act of 1950 granted to the CFIUS to review a foreign acquisition, merger, or takeover of a U.S. business that is determined to threaten the national security of the United States.
Restrictions on foreign investment in real estate also exist in many states. According to a Alien Land Ownership Guide from the National Association of Realtors, 37 U.S. states had some type of law affecting foreign ownership of real estate. Most of the laws are merely a requirement that a foreign investor register as a company doing business in the state before purchasing property. Some states specifically prohibit foreign ownership of certain types of land. One common type of real property restriction was for agricultural land. Fifteen states having some law governing foreign ownership in this area.
The Report’s recommendation for Executive Action:
To enhance their oversight of sectors subject to laws restricting or requiring disclosure of foreign investments, we recommend that the Chairman of the FCC and the Secretaries of Agriculture and Transportation review the current sources of the information their agencies currently monitor to detect changes in ownership of U.S. assets— which are subject to restriction or disclosure requirements applicable to foreign investors—and assess the value of supplementing these sources with information from other government and private data sources on investment transactions.
The Act deletes the exemption from registration in Section 203 (b)(3) of the Investment Advisers Act and replaces it with an exemption for foreign investment advisers. The (b)(3) exemption was for investment advisers with fewer than 15 clients and did hold themselves out as investment advisers. This was the exemption most often used by private investment funds.
Reporting:
“The Commission is authorized to require any investment adviser registered under this title to maintain such records and submit such reports as are necessary or appropriate in the public interest for the supervision of systemic risk by any Federal department or agency, and to provide or make available to such department or agency those reports or records or the information contained therein.”
This is a broad empowerment of the SEC to demand any report that they feel may be a systemic risk. The act fails to define “systemic risk.”
Identity of Clients
The Act would strike subsection (c) of Section 210 of the Investment Advisers Act. That subsection prohibits the SEC from requiring the disclosure of an investment advisers clients (except in a SEC proceeding or enforcement action). So Senator Reed wants investment advisers to disclose their client lists and private investment funds to disclose their investors.
Defining Clients
The Act would all the SEC to “ascribe different meanings to terms (including the term ‘client’) used in different sections” of the Investment Advisers Act. I am not sure what this change would do. I suspect it 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.
The European Commission published a draft Directive on Alternative Investment Fund Managers to establish a common regulatory and supervisory framework for all investment managers of funds promoted to investors in the European Union and not currently subject to European level regulation. Though the measure is directed at the hedge fund industry, the Directive would affect the operations of managers of all funds that are not registered as UCITS (Undertakings for Collective Investments in Transferable Securities), including private equity, real estate, infrastructure and venture capital funds.
The Directive is at an early stage of the legislative process and may be subject to significant change before it is adopted. Even in its current form it will not come into force before the end of 2011 and the proposals relating to the promotion of funds incorporated outside the EU will not come into force for a further three years after that. I expect there will intense lobbying from the financial services industry and the hedge fund industry.
The Directive is mainly driven by the European Commission’s aim to get control over what it perceives as systemic risks in unregulated fund markets. There is a set of regulations focused on managers domiciled in the EU and a second set on funds marketed in the EU.
We have another bill that is proposing to regulate private pools of capital. Yesterday, Senator Jack Reed (RI) introduced the Private Fund Transparency Act of 2009 (S.1276)
Require all hedge fund and other investment pool advisers that manage more than $30 million in assets to register as investment advisers with the SEC. The remaining smaller funds will continue to fall under state oversight.
Provide the SEC with the authority to collect information from the hedge fund industry and other investment pools, including the risks they may pose to the financial system.
Authorize the SEC to require hedge funds and other investment pools to maintain and share with other federal agencies any information necessary for the calculation of systemic risk.
Clarify other aspects of SEC’s authority in order to strengthen its ability to oversee registered investment advisers.
The text of bill has not been released yet. I am not sure it matters given that there are already two other similar bills: Hedge Fund Adviser Registration Act of 2009 and the Hedge Fund Transparency Act of 2009. On top of that, the Obama administration is finalizing their proposed plan for changing the regulatory framework of the financial industry.
I found Senator Reed’s reasoning on the need for his proposed law to be an interesting perspective:
“Private funds are not currently subject to the same set of standards and regulations as banks and mutual funds, reflecting the traditional view that their investors are more sophisticated and therefore require less protection. This has enabled private funds to operate largely outside the framework of the financial regulatory system even as they have become increasingly interwoven with the rest of the country’s financial markets. As a result, there is no data on the number and nature of these firms or ability to calculate the risks they pose to America’s broader economy.”
The SEC’s Office of Inspector General has released its Semiannual Report to Congress (.pdf). I started off looking at how the OIG feels about the new Form D for securities sold under the Regulation D exemption: “Based on our review of Form D, we determined that certain revisions should be made to the form to better ensure that potential investors are not misled by information in a form filing and to further clarify the information that is reported on the form.” [Page 32]
Illinois Public Act 096-0006 became effective on April 3, 2009, making significant changes to the operations of Illinois retirement systems, pension funds and investment boards. The Act imposes increased oversight and accountability requirements on the boards of trustees, fiduciaries and investment advisers, managers and consultants. The provisions apply not only at the state level, but at the local level, including pension systems of the City of Chicago and other local governments.
On Thursday, May 7, 2009, the House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing on: “Perspectives on Hedge Fund Registration”.
During the hearings on legislation to regulate hedge fund advisers, Rep. Paul Kanjorski said that hedge funds deserve to “continue swimming in the deep end of the pool.” But if hedge funds want to “continue to swim” in the US capital markets, they must, “fill out the forms and get an annual pool pass.”
Rep. Kanjorski also stated that “Congressmen Capuano and Castle have drafted a good bill to accomplish the goal of registering hedge fund investment advisers.” That sounds like an endorsement of the Hedge Fund Adviser Registration Act.
We saw in the Obama budget (A New Era of Responsibility) that the administration was looking to raise revenue by taxing the carried interest for private investment funds. I was waiting to see how that one line item in the budget might translate into actual legislation and a change in tax policy. Congressman Sandy Levin from the 12th District of Michigan introduced the first attempt: H.R. 1935.
The changes in H.R. 1935 are focused on taxing the carried interest only to the extent the fund managers did not have an underlying investment in the fund. The bill proposes a new section 710 to the Internal Revenue Code in Subchapter K. Any net income from an “investment services partnership interest” will be treated as ordinary income and any net loss will be treated as ordinary loss.
“Investment services partnership interest” means
any interest in a partnership which is held by any person if it was reasonably expected (at the time that such person acquired such interest) that such person (or any person related to such person) would provide (directly or indirectly) a substantial quantity of any of the following services:
(A) Advising as to the advisability of investing in, purchasing, or selling any specified asset.
(B) Managing, acquiring, or disposing of any specified asset.
(C) Arranging financing with respect to acquiring specified assets.
(D) Any activity in support of any service described in subparagraphs (A) through (C).
There is an exception for “qualified capital interest” which will not be converted to ordinary income or loss, so long as the income, gain, loss, or deduction allocated to the “qualified capital interest” is in the same manner as it is to other partners and that those allocations are significant.
“Qualified capital interest” means so much of a partner’s interest in the capital of the partnership as is attributable to:
(i) the fair market value of any money or other property contributed to the partnership in exchange for such interest,
(ii) any amounts which have been included in gross income under section 83 with respect to the transfer of such interest, and
(iii) the excess (if any) of–
(I) any items of income and gain taken into account under section 702 with respect to such interest for taxable years to which this section applies, over
(II) any items of deduction and loss so taken into account.
This would seem to prevent private investment fund managers from converting a management fee into a partnership interest in the fund. I have not figured out how this affects a performance-based promote allocation in a fund structure.
As the Congressman characterizes the legislation in his press release:
“The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates. As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation. The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.”
Since the bill was only introduced last week, it is too early to start changing things to address the changes in this bill. The bill may not pass and it may end up looking very different after it goes through the legislative meat grinder.
Garrity, Graham, Murphy, Garofalo & Flinn and PRMIA (Professional Risk Managers International Association) sponsored a webinar that focused on the signs of fraud and what you can do detect fraud in the context of hedge funds.
The agenda and my notes:
The profile of a fraudster (James Tunkey, I-OnAsia)
The psychology of the gullible investor (Stephen Greenspan Ph.D., Clinical Professor of Psychiatry, University of Colorado)
Current legal and regulatory requirements for hedge funds (Philip Thomas, Esq., Garrity Graham)
A hedge fund insider’s view (Samuel Won and Greg Ivancich, Global Risk Management Advisors, Inc.)
The regulatory future for hedge funds (Philippa Girling, Esq., FRM, Garrity Graham)
James Tunkey of I-OnAsia, started off with The Profile of a Fraudster. He is a certified fraud examiner. His focus was on the incentives, structures and control systems in an organization.
James put forth the proposition that Fear, Greed, and Honor are the three drivers of fraud. In the context of private investment funds, they are driven by the fear and honor of not making investment targets. There is greed trying to make more money for themselves.
Stephen Greenspan focused on the psychology of the gullible investor. (He has a new book out Annals of Gullibility and an article in the Wall Street Journal: Why We Keep Falling For Financial Scams.) Everybody is capable of being scammed (and probably have been). Stephen has also been scammed. He was a Madoff investor. He breaks a foolish action into three different groups: (1) practically foolish act, (2) non-induced socially foolish action, and (3) induced socially foolish action. It is this induced socially foolish that is gullibility.
Stephen pointed out that investor mania is like a Ponzi scheme. The early investors tell others about how wonderful their investments performed. There is a social feedback loop that drives the mania. The scam artists are skilled manipulators at using these factors.
Phillip Thomas looked at some regulations in place and steps you can take as part of the diligence. He pointed out that in today’ s environment, it is not a good time to be cutting back on compliance. He led a discussion through some recent court cases to highlight some of the issues.
Disclosure, potentially manipulative practices, and valuation are three hot regulatory topics. There are several rules in place limiting the sale and reconciliation of securities. As for valuation, you should have a segregation of responsibilities and oversight.
Some tools that don’t work very well.
The due diligence questionnaire. These are probably canned responsibilities and are unlikely to uncover problems
Form ADV. Also have canned answers
Interview of Managers. He thinks this is a good a tactic, at least as a smell test.
References. The problem is that they will only give you good references.
He thinks out that you should run a background investigation of the principals.
He moves on to some best practices for due diligence:
Don’t take anything from the fund manager at face value
Be suspicious of a manager limiting access to information
Consult specialist professionals who will be able to spot irregularities
Pay attention to what industry leaders are saying and doing about best practices.
Samuel Won and Greg Ivancich presented the view from inside a hedge fund. They believe people were too busy chasing returns during the extended bull market to spend time and energy on due diligence. Too many people just did check the box diligence and did not take a close look. Investors did not look at the underlying processes and operations at their investment funds.
They also see a regulatory sea change coming, likely to be draconian and over-reaching. They expect to see changes in requirements from institutional investors. Firms may also use the existence of their risk management and compliance as competitive differentiators. There will also be some new best practices emerging.
They see a need for independence. it is important not just to have an independent audit of financial statements, but also of infrastructure, processes, controls, investment style, valuation, and risk management.
Philippa Girling looked at the global political reaction to the current crisis and how it will affect hedge fund regulation. Germany and France are pushing for deeper regulation that the U.S. IMF is also pushing. (Any country using the term “shadow financing” wants more regulation.) The European Union as a whole is looking to regulate hedge funds.
Establish appropriate protections to meet anticipated regulations and investor demands. (We have already seen the Obama administration putting a short time line on enacting regulatory problems.)
Evaluate risk
Manage compliance
Ensure Anti-Money laundering procedures are in place
Conduct fraud assessments
Review current documents for improvement to current best practices
Be ready for enhanced due diligence visits from potential investors
Some of the more interesting questions from the Q&A sessions:
What are the most important red flags?
A manager not delivering information, instead standing alone on their reputation
Lack of third party administrator/custodian
Will regulation just lead to more avoidance?
SEC registration does not mean there has been an effective review
The UK centralized model takes away the US regulatory arbitrage (different agencies reviewing different types of investment companies)
