Senators Grassley and Levin Introduce Hedge Fund Transparency Act

January 30, 2009

Yesterday, Senators Charles Grassley (R-IA) and Carl Levin (D-MI) introduced the Hedge Fund Transparency Act ("HFTA"), which would require hedge funds, private equity and other private funds with $50 million or more in assets, or assets under management, to register with the Securities and Exchange Commission ("SEC"), notwithstanding the availability of exemptions from registration for privately offered funds under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 ("1940 Act"), as renumbered.

The senators said their legislation is needed because of the 2006 decision by the D.C. Circuit Court of Appeals that overturned Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 ("Advisers Act").  Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).  Rule 203(b)(3)-2 would have required hedge fund managers to register as investment advisers. Unlike Rule 203(b)(3)-2 under the Advisers Act, the HFTA would require funds, rather than the managers, to register with the SEC.  HFTA also diverges from S. 1402, the Hedge Fund Registration Act of 2007, which Senator Grassley introduced to the Senate in May 2007, and which similarly would have required hedge fund managers to register as investment advisers.

Conditions for Exemption from Investment Company Registration for Hedge Funds

Under HFTA, new Sections 6(a)(6) and 6(a)(7) of the 1940 Act would replace current Sections 3(c)(1) and 3(c)(7) without substantive change, except that those subsections would now be exemptions from registration, rather than exceptions to the definition of "investment company."

Notwithstanding the availability of the investment company registration exemptions of new Sections 6(a)(6) and 6(a)(7), investment funds with assets, or assets under management, of not less than $50 million would be exempt from registration as investment companies only if they register with the SEC pursuant to new Section 6(g)(1) of the 1940 Act and comply with certain reporting requirements.

In particular, funds claiming the Section 6(g)(1) exemption from investment company registration would be required to:

  1. Register with the SEC;
  2. Maintain books and records as the SEC would require;
  3. Cooperate with any request by the SEC for information or examination; and
  4. File an annual information form with the SEC electronically, in which the fund would be required to disclose:
    1. The name and current address of each individual who is a beneficial owner of the investment company;
    2. The name and current address of any company with an ownership interest in the investment company;
    3. An explanation of the structure of ownership interests in the investment company;
    4. Information on any affiliation with another financial institution;
    5. The name and current address of the investment company"s primary accountant and primary broker;
    6. A statement of any minimum investment commitment required of a limited partner, member, or investor;
    7. The total number of any limited partners, members, or other investors; and
    8. The current value of the assets of the company and the assets under management by the company.

Notably, the SEC would be required to make the filed information form available to the public at no cost and in an electronically searchable format.  The SEC would be required to issue forms and guidance to implement the HFTA within 180 days after its enactment.

Anti-Money Laundering ("AML") Requirements

In addition to the registration requirements, the HFTA includes provisions, added by Senator Levin, requiring investment funds that are exempt from registration under new Sections 6(a)(6) or 6(a)(7) to establish AML programs and report suspicious transactions under the Bank Secrecy Act ("BSA"). 31 U.S.C. 5318(g) and (h).  Currently, only registered investment companies are subject to BSA requirements.  In October 2008, the U.S. Treasury withdrew proposed rules that would have required unregistered investment companies to implement AML programs. Within 180 days of the enactment of the HFTA, the Treasury Secretary, in consultation with the SEC and Commodity Futures Trading Commission would be required to issue a final rule setting forth minimum requirements for the AML program and reporting of suspicious transactions.  Unlike the rules for registered investment companies, the rule would require exempted investment companies to "use risk-based due diligence policies, procedures, and controls that are reasonably designed to ascertain the identity of and evaluate any foreign person (including, where appropriate the nominal beneficial owner or beneficiary of a foreign corporation, partnership, trust or other foreign entity) that supplies funds or plans to supply funds to be invested with the advice or assistance of such investment company."  The rule would also require exempted investment companies to produce account records related to AML compliance requested by a federal banking regulator under 31 U.S.C. 5318(k)(2).  If a final rule were not issued, the requirements would take effect one year after the date of enactment of the HFTA.

The AML obligations in the Act are similar to provisions that were included in the "Stop Tax Haven Abuse Act," S.681, available at http://www.govtrack.us/congress/bill.xpd?bill=s110-681, introduced by Senator Carl Levin, Senator Norm Coleman, and then-Senator Barack Obama in February of 2007 following the issuance in August of 2006 by the U.S. Senate Permanent Subcommittee on Investigations of a report into the use of tax havens and offshore entities by U.S. taxpayers to avoid U.S. taxes and creditors.  A copy of the report is available on the Senate website.

Observations

It is not clear whether and when this legislation will be taken up by the Senate Banking Committee.  On one hand, the seniority and importance of the Senators sponsoring the legislation, and the high profile subject matter, cause us to believe that it will be given serious consideration.  On the other hand, neither Senator is a member of the committee of jurisdiction, which already has a full agenda.  While it is unlikely that HFTA would move as a standalone measure, pieces of the legislation may well become part of the larger regulatory reform bill that the committee will take up at some point during this Congress.

Another variable is the approach taken in the legislation that would require hedge funds rather than their managers to register with the SEC.  Presumably, an intent of the legislation is to answer the call for greater transparency about hedge funds in order to enable a regulator to monitor systemic risk.  The legislation, however, focuses on providing greater transparency about hedge funds’ owners, and not about their investments, leverage or counterparty exposure.

In addition to the uncertainty about whether (and why) the bill would require fund rather than investment adviser registration, other points of note are:

  • Although denominated as addressing "Hedge Fund" transparency, "hedge fund" is not defined, and the bill would apply to all investment vehicles that were previously relying on Section 3(c)(1) or 3(c)(7) of the 1940 Act.  This includes many types of pooled investment vehicles such as private equity funds, venture capital funds, distressed debt funds and certain financial product vehicles, in addition to funds that are commonly referred to as hedge funds.
  • The annual reporting of names and addresses purports to apply to require disclosure of all owners of the investment company.  No other provision of the federal securities laws requires disclosure of the names of persons who make insignificant, passive investments in an investment vehicle.  Moreover, it is difficult to see how public disclosure of this information advances the governmental interest in improving oversight by a regulatory agency of systemic risk.  We expect this provision to receive significant opposition.
  • The jurisdictional reach of the bill, namely its application to non-US funds with US investors, is unclear.
  • Investment managers who are registered advisers under the Advisers Act are already subject to books and records requirements and SEC examination pursuant to the Advisers Act.  It is unclear how the books and records and SEC examination requirements of HFTA – that would be imposed on the funds themselves – would interact with the Advisers Act"s requirements applicable to registered investment managers.
  • The bill leaves open the question of whether the Financial Industry Regulatory Authority (FINRA) or some other "self-regulatory organization" will have examination responsibilities with respect to managers or hedge funds.  However, unlike the statutory framework for broker-dealers, there is no provision for self-regulation in either the 1940 Act or the Advisers Act.
  • Unlike most AML requirements, the AML obligations would become self-executing and enforceable one year after the effective date of the Act even if Treasury does not issue a final rule.  This new provision may have been included in response to Treasury"s suggestion, when withdrawing its proposed AML program rule, that it may not impose BSA requirements on unregistered investment companies.

We continue to monitor legislative and regulatory developments related to hedge fund registration and regulation and will issue further updates as these significant events unfold.

Gibson, Dunn & Crutcher LLP

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