SEC Staff Releases Report on Hedge Funds

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1 By Michael P. Malloy Click the image to view our investment management capabilities Michael P. Malloy Drinker Biddle & Reath LLP Philadelphia, PA (fax) Philadelphia New York Washington Los Angeles San Francisco Princeton Florham Park Berwyn Wilmington

2 On September 29, 2003, the Securities and Exchange Commission (the SEC ) staff issued a report to the SEC entitled Implications of the Growth of Hedge Funds. The report was prepared by the staff at the SEC s request and is the culmination of the SEC s study on the hedge fund industry. The report outlined the staff s factual findings, identified its concerns, and recommended changes to the SEC to improve the current system of hedge fund regulation and oversight. The staff s concerns included: (i) the inability of the SEC to examine hedge fund investment advisers and to evaluate the effect of the strategies used in managing hedge funds on the financial markets; (ii) the lack of regulatory measures to ensure that material information to assist investors is available; (iii) the disclosure of useful information provided to investors about a hedge fund investment adviser; (iv) the need for improved disclosure regarding conflicts of interest of hedge fund investment advisers; and (v) the valuation by hedge fund investment advisers of the fund s assets. Chairman William Donaldson and Paul Roye, Director of the Division of Investment Management, emphasized that the report is the staff's recommendations and that the SEC has expressed no view regarding the staff s analysis, findings or conclusions. The staff's recommendations are summarized below. Registration of Hedge Fund Investment Advisers The staff's principal recommendation was to require the registration of hedge fund investment advisers. The staff recommended amending Rule 203(b)(3)-1 under the Investment Advisers Act of 1940 (the Advisers Act ) to require hedge fund investment advisers to look through any hedge funds they manage and count each separate investor as a client. The staff believes this recommendation would require most hedge fund investment advisers to register. The staff also recommended an assets under management threshold for requiring hedge fund investment advisers to register. The staff noted that it believes Advisers Act registration is the least intrusive form of hedge fund registration available, and that registration would not: (i) impede how a hedge fund investment adviser invests or operates a fund; (ii) restrict the investment adviser s ability to trade securities, use leverage, sell short or enter into derivative transactions; (iii) require the disclosure of proprietary trading strategies; or (iv) result in public identification of a fund s investors. The staff identified the following benefits of investment adviser registration: (i) helping to deter fraud; (ii) fostering strong compliance procedures; (iii) allowing the SEC to collect industry information; and (iv) raising minimum investment standards. By requiring investment advisers to register, the wealth standards for direct hedge fund investors would, in most instances, increase. The Advisers Act requires an investor to be a qualified client and to have $750,000 invested with an investment adviser or a net worth of $1.5 million for the investment adviser to charge a performance fee. This wealth standard is substantially higher than the 2

3 accredited investor standard for a private placement offering of a Section 3(c)(1) fund. The staff acknowledged the costs of registration, including electronic filings, recordkeeping systems and ongoing regulatory compliance expenditures. The staff also noted that the SEC should consider the strain of registration on the SEC s resources. Hedge Fund Brochure The staff recommended adopting a rule to require hedge fund investment advisers to file and deliver to investors a disclosure statement tailored to meet the needs of hedge fund investors. The required disclosure would include basic information for investors and prospective investors such as conflicts of interest, risk management measures, security valuation and lock-up periods. The disclosure document would require periodic updates. Board Adopted Valuation Procedures The staff recommended adopting a rule that prohibits all registered investment companies ( RICs ), including registered fund of funds, from investing in the securities of hedge funds unless the RIC s board has adopted fair value procedures that allow assets to be valued in accordance with the Investment Company Act of 1940 (the 1940 Act ). The staff, however, emphasized that it did not recommend mandating specific procedures that a RIC must follow in valuing its assets. Additional Disclosure of Layered Fees The staff recommended that the SEC adopt rules regarding the layering of fees in RICs. The rules would require all RICs, including registered fund of funds, that invest all or substantially all of their assets in hedge funds to disclose in their fee tables the estimated fees and expenses of the underlying funds. The fee disclosure would include asset and performance based fees. The staff believes the disclosure would allow an investor to accurately evaluate his or her investment goals against the cost of the investment in the RIC. General Solicitation for Section 3(c)(7) Funds Section 3(c)(7) of the 1940 Act permits funds that are exempt from registration to be sold to investors who are qualified purchasers. Qualified purchasers are subject to significantly greater wealth standards than other types of hedge fund investors. The staff recommended eliminating the prohibition of general solicitation and general advertising in the private placement offerings of Section 3(c)(7) funds. Additional Staff Recommendations and Measures Suitability. The staff did not recommend specific suitability measures for hedge funds, but encouraged the NASD and the SEC staffs to continue to vigilantly identify violations of broker-dealer suitability obligations. 3

4 Prime Broker Capital Introduction Services. The staff encouraged examiners to carefully examine prime broker capital introduction services to ensure prime brokers are complying with applicable regulatory requirements. Best Practices. The staff encouraged the hedge fund industry to embrace and refine existing best practices, and to expand and develop additional best practice guidelines to further investor protections and enhance hedge fund operations. Investor Education. The staff recommended that the SEC continue to provide and enhance investor education relating to hedge funds and registered fund of funds. Absolute Return Strategies for Mutual Funds and Closed-End Funds. The staff recommended that the SEC issue a concept release exploring facilitating the wider use of hedge fund-type/absolute return strategies ( absolute return strategies ) in mutual funds and closed-end funds. The staff believes investors in these funds may receive benefits from these investment strategies. The staff suggested that the concept release could address issues such as: (i) identifying appropriate absolute return strategies for different investment company structures; (ii) evaluating the effect of the 1940 Act restriction on leverage and short-selling on the use of absolute return strategies in RICs; (iii) considering appropriate fee arrangements between investment advisers and RICs using absolute return strategies; and (iv) determining whether investor education would be helpful with hedge fund-type/absolute return products. * * * 4

5 Michael P. Malloy is a partner in the Investment Management Group of Drinker Biddle & Reath LLP, a full service law firm of more than 450 lawyers that was founded in Michael E. Dresnin, an associate in the Investment Management Group, assisted with preparation of this article. One Logan Square 18 th & Cherry Streets Philadelphia, PA (fax) Michael.Malloy@dbr.com Philadelphia New York Washington Los Angeles San Francisco Princeton Florham Park Berwyn Wilmington 2003 Drinker Biddle & Reath LLP, a Pennsylvania limited liability partnership. All rights reserved. This discussion is not intended to constitute legal advice regarding any client s legal problems or specific questions and should not be relied upon as such. The article was first published in the Summer 2003 issue of The Investment Adviser s Counsel. Reprinted by permission. 5