United States: Castle And Capuano Propose Hedge Fund Regulation Package

Representatives Michael Castle (R-DE) and Michael Capuano (D-MA), introduced a package of legislation last week aimed at regulating the hedge fund industry. As discussed in our January 30, 2009 Client Alert, Senators Charles Grassley (R-Iowa) and Carl Levin (D-Mich.) recently introduced a similar measure in the U.S. Senate.

The legislative package introduced by Representatives Castle and Capuano includes three bills that seek to (1) compel registration under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), of private investment fund managers previously exempted under the Advisers Act; (2) require pension plans to disclose their hedge fund investments and (3) direct the President's Working Group on Financial Markets to study and report on the hedge fund industry, including recommendations for action to the Congress. Each bill is discussed in greater detail below.

Hedge Fund Adviser Registration Act of 2009

The Advisers Act generally requires investment advisers to register with the Securities and Exchange Commission (the "SEC"). General partners and investment managers of private investment funds, such as hedge funds, generally fit the Advisers Act definition of "investment adviser" as they, for compensation, engage in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities. However, general partners and investment managers often satisfy the requirements of the "private adviser" exemption set forth in Section 203(b)(3) of the Advisers Act, and thus avoid registration.

Under current law, an investment adviser may avail itself of the "private adviser" exemption only if the investment adviser:

Notably under current law, a single "client" can consist of one legal entity, such as a limited partnership operating as an investment fund, which itself may have far in excess of 15 underlying limited partners as investors.

The proposed Hedge Fund Adviser Registration Act of 2009, if enacted, would completely eliminate the "private adviser" exemption. General partners and investment managers of private investment funds currently relying on such exception would be required to register with the SEC.

This is not the first time the "private adviser" exemption has been the focal point in efforts to regulate hedge funds. A 2004 SEC regulation re-defined the term "client" as used in regulations under the Advisers Act in a manner that "looked through" legal entities, like limited partnerships operating as investment funds, and required counting of all the underlying investors in each such fund managed by an investment adviser in determining whether the 15 client limit had been reached — rather than treating the fund itself as a single "client." As most hedge funds have more than 15 underlying investors, the effect of the SEC regulation was that the vast majority of all general partners and investment managers of hedge funds could no longer rely on the "private adviser" exemption from registration under the Advisers Act.

New York fund manager Philip Goldstein of Bulldog Investors took exception to the regulation, filing a lawsuit to challenge its enforcement. In 2006, the United States Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC found that the SEC's new definition of "clients" constituted an impermissible use of the agency's rule-making authority, and thus struck down the SEC regulation as an arbitrary and capricious attempt to require the registration under the Advisers Act of general partners and investment managers of hedge funds that Congress had decided to exempt. Only six days later, Rep. Barney Frank (D-Mass) introduced H. 5712, "The Securities and Exchange Commission Authority Restoration Act of 2006," which proposed amending the definition of "client" in the Advisers Act itself to accomplish exactly what the D.C. Circuit told the SEC it could not do by regulation. The Bill died in committee.

Although general partners and investment managers are currently exempt from registration under the Advisers Act, they nonetheless remain subject to a number of the Advisers Act provisions, including the antifraud provisions. However, if general partners and investment managers are required to register, they will become subject to all provisions of the Advisers Act, including those provisions regarding annual disclosure requirements, performance fee prohibitions, advertising and marketing restrictions and recordkeeping requirements.

Pension Security Act of 2009

The second bill introduced by Representatives Castle and Capuano, the Pension Security Act of 2009, would amend Title I of the Employee Retirement Income Security Act of 1974 ("ERISA") to require, in the annual report of each defined benefit pension plan, disclosure of plan investments in hedge funds. The disclosure would specifically include a schedule identifying each hedge fund in which the plan invests as of the end of the plan year covered by the annual report and the amount so invested in each hedge fund.

For purposes of the amendment, the term "hedge fund" means an investment pool that (i) is excluded as an investment company under sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, and (ii) offers its securities pursuant to an exemption for private offerings provided by Section 4(2) of the Securities Act of 1933 and Rule 506 of Regulation D promulgated thereunder.

If passed, defined benefit pension plans would be required to make disclosures in their annual reports for plan years beginning on or after the date of the enactment. The bill also directs the Secretary of Labor, in consultation with the SEC, to issue regulations to carry out the amendments not later than 1 year after the date of the enactment.

Hedge Fund Study Act

The third bill introduced by Representatives Castle and Capuano, the Hedge Fund Study Act, would require the President's Working Group on Financial Markets to conduct a study on the hedge fund industry. Specifically, the study would include an analysis of:

• the changing nature of hedge funds and what characteristics define a hedge fund;
• the growth of hedge funds within financial markets;
• the growth of pension funds investing in hedge funds;
• whether hedge fund investors are able to protect themselves adequately from the risk associated with their investments;
• whether hedge fund leverage is effectively constrained;
• the potential risks hedge funds pose to financial markets or to investors;
• various international approaches to the regulation of hedge funds; and
• the benefits of the hedge fund industry to the economy and the markets.

The study must be completed no later than 180 days after the date of enactment, when the President's Working Group on Financial Markets must submit a report on its findings to the Committee on Financial Services of the House of Representatives and the Committee on Banking, Housing, and Urban Affairs of the Senate. The report must include the following recommendations:

• any proposed legislation relating to appropriate disclosure requirements for hedge funds;
• the type of information hedge funds should disclose to regulators and to the public;
• any efforts the hedge fund industry or regulators of financial institutions should undertake to improve practices or provide examples of successful industry initiatives; and
• any oversight responsibilities that members of the President's Working Group should have over the hedge fund industry, and the degree and scope of such oversight.

This is also not the first time lawmakers have proposed the President's Working Group on Financial Markets study and report on the hedge fund industry. In 1999 the President's Working Group issued a report assessing lessons learned in the wake of the near-collapse of Long Term Capital Management. In February 2007, the President's Working Group released a set of principles and guidelines that were to guide U.S. financial regulators as they address public policy issues associated with the rapid growth of private pools of capital, including hedge funds. In 2008, the President's Working Group released a set of best practices for hedge fund investors and asset managers.

Bracewell & Giuliani is committed to keeping clients and friends immediately apprised of new legislative proposals as the 1st session of the 111th Congress demonstrates that sweeping reform of the financial services industry, and private investment funds and their general partners and investment managers, will be at the center of the agenda.

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