Investment Management OCTOBER 2003

Transcription

1 Investment Management OCTOBER 2003 SEC Staff Issues Hedge Fund Report On September 29, 2003, the staff of the Securities and Exchange Commission ( SEC ) released its long-anticipated report on the hedge fund industry and the implications of the industry s growth for purposes of regulation. The report, entitled Implications of the Growth of Hedge Funds (the Report ), is the result of the staff s research and study of the industry, of which the Hedge Fund Roundtable, a public forum hosted by the SEC on May 14, 2003, was a key part. The Report outlines the staff s factual findings regarding the industry, identifies regulatory concerns, and makes recommendations to the SEC regarding improvement of the current system of regulation and hedge fund oversight. As a report of the staff, the Report expresses the views of the staff and not the SEC itself or of individual Commissioners. SCOPE OF THE REPORT The Report represents a comprehensive study of the hedge fund industry by the staff, and the majority of the Report is devoted to a thorough exposition of the regulatory framework governing hedge funds and their characteristics, organization and operations. As an initial matter, the staff acknowledges in the Report that there exists no universally accepted definition of hedge fund and, significantly, notes that the Report does not apply to private equity funds, venture capital funds, and commodity pools. The Report focuses attention on the SEC s lack of information regarding hedge funds within the context of the growth and increasing importance of the industry. The Report does not advocate wholesale regulation of hedge funds, but suggests a need for regulators and investors to have access to an increased level of information. The Report s major recommendations are that advisers to hedge funds register as investment advisers under the Investment Advisers Act of 1940 ( Advisers Act ) and the elimination of the prohibition on general solicitation in the sale of funds relying on Section 3(c)(7) under the Investment Company Act of 1940 ( Investment Company Act ). CONCERNS RAISED IN THE REPORT The Report identified a number of significant concerns in connection with the growth of the hedge fund industry: Lack of SEC Regulatory Oversight of Hedge Funds n The SEC s inability to inspect hedge funds not having a registered investment adviser has made it difficult to detect misconduct until after the fact. n Lack of SEC oversight of hedge funds and their advisers has left the SEC with relatively little knowledge of an increasingly important segment of the investment industry. Lack of Independent Checks on Valuation of Hedge Fund Portfolio Assets by Advisers n The combining of incentive fees and broad discretion regarding portfolio valuation raises issues about the fairness and accuracy of portfolio asset valuations. Retailization of the Hedge Fund Industry and Protection of Investors n Although more investors qualify as accredited investors, the staff did not uncover evidence Kirkpatrick & Lockhart LLP

2 of significant numbers of retail investors making direct investments in hedge funds. n The staff s concern about protecting retail investors is, however, amplified by the possibility that in the future retail investors may be offered indirect access to hedge funds through funds of hedge funds ( FOHF ) that are registered under the Investment Company Act. In particular, the staff notes concerns over the reliability of such funds calculation of net asset value due to lack of transparency. Lack of transparency also may increase risks related to a registered FOHF s lack of actual, as opposed to intended, diversification. n Increased institutional investment in hedge funds indirectly exposes participants in pension plans and similar vehicles to otherwise unregulated investments. Hedge Funds are not subject to Any Minimum Disclosure Requirements Conflicts of Interest n Side-by-side management of hedge funds and other accounts may cause conflicts due to hedge fund incentive fees and conflicts in share selling strategies, which could cause an adviser to favor hedge fund clients over other clients. n The lack of disclosure relating to the payment of fees and provision of services by prime brokers to hedge funds may mask conflicts. Compliance with General Solicitation Requirements in Private Offerings n Marketing practices of some advisers, especially in use of the internet, raise concerns that the prohibition against general solicitation in a private offering of securities is not being rigorously observed. Concerns Over Whether Current Laws and Regulations Impair the Ability of Registered Investment Companies to Utilize Hedge-like Strategies n The staff is concerned that certain restrictions on registered investment companies and their advisers may restrict the ability of registered funds to utilize certain beneficial strategies utilized by hedge funds. RECOMMENDATIONS The Report contains a number of recommendations to the SEC: Hedge Fund Advisers Should Register as Investment Advisers under the Advisers Act n The SEC should redefine client in Rule 203(b)(3)-1 of the Advisers Act to require hedge fund advisers to look through any hedge funds that they manage to count each separate investor as a client. Such a change would shift the emphasis from the number of hedge funds advised by an adviser to the size of the adviser in terms of clients and assets. n The staff states that requiring adviser registration is the least intrusive of alternatives and would not cause significant changes in hedge fund operations. Registration as investment advisers would allow the SEC to conduct examinations of hedge fund advisers, which the staff states would foster stronger compliance programs. Advisers would be required to make certain disclosures in filings with the SEC, maintain prescribed books and records, and safeguard client assets under custody rules. The advisers also would become subject to the SEC s proposed Compliance Rule, if and when adopted, which would require advisers to have compliance programs, review them regularly, and to have a chief compliance officer. 1 Registering hedge fund advisers as investment advisers effectively would result in only qualified clients under Rule (a person or company with a $1.5 million net worth or $750,000 under management with the adviser) investing in Section 3(c)(1) funds if such funds charge performance fees, which would obviate any need, in the staff s view, to raise the accredited investor income eligibility levels in Regulation D under the Securities Act of The staff has not recommended any changes to the accredited investor standards. 1 Compliance Programs for Investment Companies and Investment Advisers, Advisers Act Release No (Feb. 5, 2003) (the Compliance Rule ). Kirkpatrick & Lockhart LLP 2

3 In addition, registration of advisers would impose costs related to filing and, most significantly, ongoing regulatory compliance. The SEC Should Require Advisers to Provide a Brochure Specifically Designed for Hedge Funds Such a brochure apparently would be in addition to the Adviser s Form ADV Part II. Such a brochure would provide disclosure regarding conflicts, risk management, and valuation of assets. The staff believes that such disclosure should appear in a brochure regardless of whether the information appears in a fund s private placement memorandum. The SEC Should Require Registered FOHFs to have Board-Approved Valuation Procedures Such a rule would prohibit all registered investment companies, including registered FOHFs, from investing in hedge funds unless their boards of directors have adopted procedures designed to ensure good faith fair valuation of portfolio assets. The staff does not recommend, however, that such a rule mandate specific procedures that a fund must follow in valuation. The staff views such a rule as addressing its concerns regarding registered FOHF diversification risk. The SEC Should Require Additional Disclosure Regarding Layering of Fees in Registered FOHF Structures The staff recommends that the SEC adopt its recently proposed rule under Section 12(d)(1) of the Investment Company Act requiring that all registered investment companies, including FOHFs, disclose in their prospectus fee table the estimated fees (both asset based and performance based) and expenses of underlying funds in which they invest. (The proposed rule is not publicly available for review at the time of this Alert.) The SEC and Other Regulators Should Continue to Monitor Whether Broker Suitability Obligations in the Sale of Hedge Funds Are Met The staff does not recommend that any measures be taken with regard to suitability determinations at this time, noting that regulators are carefully focusing their examinations of broker-dealers on suitability of hedge fund sales, and that such actions have been effective. The SEC Should Permit General Solicitation in Section 3(c)(7) Hedge Fund Offerings Because Section 3(c)(7) funds may be sold to an unlimited number of investors that meet qualified purchaser standards, the staff sees little compelling policy justification to prohibit general solicitation or advertising in private placements available only to qualified purchasers. The staff, however, did not address any implications under other laws and regulations regarding its recommendation to allow general solicitation. The staff did indicate its reluctance to ease general solicitation prohibitions regarding hedge funds or other funds that solely use an accredited investor standard. The SEC Should Monitor Introduction Services Provided by Prime Brokers The staff questions whether capital introduction services ( dating service activities) run by prime brokers should be subject to additional disclosures regarding conflicts of interest. The staff encourages examiners to be vigilant in examining such services by prime brokers, and prime broker activities may become a significant focus of SEC inspections. The Hedge Fund Industry Should Further Develop and Utilize Best Practices The staff applauds the development of best practices guidelines by industry groups and encourages the expansion of such best practices. Investor Education The staff believes that improvements in disclosure will assist in investor education, but recognizes practical limits on assisting retail investors in making informed choices regarding hedge funds and FOHFs. RECOMMENDATION THAT THE SEC ISSUE A CONCEPT RELEASE REGARDING THE WIDER USE OF HEDGE FUND STRATEGIES IN REGISTERED INVESTMENT COMPANIES The staff addresses at some length the differences between hedge fund and investment company strategies, and the benefits and challenges posed to registered investment companies by absolute return strategies. The staff recommends that the SEC issue a concept release seeking information regarding any statutory or regulatory changes that may be needed or beneficial regarding investment company use of absolute return strategies and whether retail investors have the ability to understand such strategies. In Kirkpatrick & Lockhart LLP 3

4 expanding the use of strategies based on leverage and short selling, the release also should request comment on whether the Investment Company Act s restrictions impair the effective use by registered funds of such strategies, and whether the use of certain types of derivatives by registered funds may be useful. CONCLUSION The staff s Report does not suggest hostility to the further development of the industry, and the concerns that the staff raised in the Report neither indicate widespread troubles within the industry nor that a broad regulatory response is needed. Based on the recommendations in the Report, hedge fund managers that are not registered investment advisers should begin planning regarding any changes that may be necessary in their organization and operations if they are required to register, including the need for a compliance officer, meeting custody requirements, and the numerous policies and procedures that likely will become necessary when the SEC adopts the proposed Compliance Rule applicable to registered advisers. MICHAEL S. CACCESE mcaccese@kl.com MARK P. GOSHKO mgoshko@kl.com NICHOLAS S. HODGE nhodge@kl.com ROBERT H. ROSENBLUM rrosenblum@kl.com GEORGE J. ZORNADA gzornada@kl.com Kirkpatrick & Lockhart LLP 4

5 Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States, with more than 60 lawyers devoting all or a substantial portion of their practice to this area and its related specialties. The American Lawyer Corporate Scorecard, published in April 2003, lists K&L as a primary legal counsel to the investment companies, board members or advisory firms for 15 of the 25 largest mutual fund complexes. No law firm was mentioned more frequently in the Scorecard. We represent mutual funds, closed-end funds, insurance companies, broker-dealers, investment advisers, retirement plans, banks and trust companies, hedge funds, offshore funds and other financial institutions. We also regularly represent mutual fund distributors, independent directors of investment companies and service providers to the investment management industry. In addition, we frequently serve as outside counsel to industry associations on a variety of projects, including legislative and policy matters. We work with clients in connection with the full range of investment company industry products and activities, including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of the investment company business. We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also visit our website at for more information, or send general inquiries via to investmentmanagement@kl.com. BOSTON Michael S. Caccese mcaccese@kl.com Philip J. Fina pfina@kl.com Mark P. Goshko mgoshko@kl.com Thomas Hickey III thickey@kl.com Nicholas S. Hodge nhodge@kl.com LOS ANGELES William P. Wade wwade@kl.com NEW YORK Beth R. Kramer bkramer@kl.com Richard D. Marshall rmarshall@kl.com Robert M. McLaughlin rmclaughlin@kl.com Loren Schechter lschechter@kl.com SAN FRANCISCO Eilleen M. Clavere eclavere@kl.com Jonathan D. Joseph jjoseph@kl.com David Mishel dmishel@kl.com Mark D. Perlow mperlow@kl.com Richard M. Phillips rphillips@kl.com WASHINGTON Clifford J. Alexander calexander@kl.com Diane E. Ambler dambler@kl.com Catherine S. Bardsley cbardsley@kl.com Arthur J. Brown abrown@kl.com Arthur C. Delibert adelibert@kl.com Robert C. Hacker rhacker@kl.com Benjamin J. Haskin bhaskin@kl.com Kathy Kresch Ingber kingber@kl.com Rebecca H. Laird rlaird@kl.com Thomas M. Leahey tleahey@kl.com Cary J. Meer cmeer@kl.com R. Charles Miller cmiller@kl.com Dean E. Miller dmiller@kl.com R. Darrell Mounts dmounts@kl.com C. Dirk Peterson dpeterson@kl.com Alan C. Porter aporter@kl.com Theodore L. Press tpress@kl.com Robert H. Rosenblum rrosenblum@kl.com William A. Schmidt william.schmidt@kl.com Lynn A. Schweinfurth lschweinfurth@kl.com Donald W. Smith dsmith@kl.com Robert A. Wittie rwittie@kl.com Robert J. Zutz rzutz@kl.com Kirkpatrick & Lockhart LLP Challenge us. BOSTON... n DALLAS n HARRISBURG n LOS ANGELES n MIAMI n NEWARK n NEW YORK n PITTSBURGH n SAN FRANCISCO n WASHINGTON This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.