The hedge fund registration requirements debated extensively in the blawgosphere a few months back (see, e.g., here, here, and here) will take effect on Wednesday of next week. According to this article in the W$J, so far 530 hedge fund advisers have registered and a few hundred more are expected before Wednesday. Recent estimates put the number of hedge funds at around 8,000 (although the number may be on the decline). So why haven’t there been more registrations? Well, the rules do not require registration if customers cannot withdraw money from an adviser’s fund for two years or more or if the fund is not taking new investors. Hence, a number of advisers have increased the lockup period for their funds to two years and others have closed their funds to new investors. Additionally, some hedge funds advisers have previously registered or are waiting to register pending the outcome of litigation challenging the rules (see this article).
The SEC’s reasons for adopting the new rules include the incredible growth of hedge fund assets, the fact that some hedge funds have expanded their marketing to attract retail investors, the gradual and detectable decline in investment minimums, and fraud deterrence. The SEC believes that fraudsters are attracted to the hedge fund industry specifically due to the lack of oversight. Likewise, the SEC hopes that similar to tax audits the prospect of random compliance examinations will serve to deter fraud. You can quibble with whether these reasons warrant additional regulation and whether adviser registration is the right answer (and many have). But if the SEC truly believes additional regulation is warranted and adviser registration is the right answer, why did they draft rules that appear to result in less than 25% of hedge fund advisers registering?
For a brief overview of the new rules (put together by my research assistant, Ron Taylor), see below the fold.
Under Rule 203(b)(3)-2 of the Investment Advisers Act of 1940, hedge fund advisers with 15 or more investors and $30 million or more under management will be required to register with the SEC as investment advisers. Advisers with less than $30 million under management will continue to be exempt.
Counting “owners� – In fund of fund situations where a hedge fund will invest a portion of its assets with a another hedge fund, those hedge fund advisers will be required to “look through� the fund and count each investor in the fund investor as an individual client per the rule requiring hedge fund advisers with greater than 15 clients to register. Certain insiders, key employees, seed investors, and family members will not be counted toward the 15 client threshold. Likewise, these individuals’ investments will also not be counted towards the $30 million assets under management cut off.
Qualified investors – Hedge fund advisers who charge performance fees will be barred from accepting investments from clients who have a net worth below $1.5 million or less than $750,000 under management with the adviser. Existing clients who fall below these thresholds will be grandfathered.
Records and documentation – Hedge fund advisers will be required to keep accurate records and books regarding the investment advisery business. Rule 204-2 requires SEC-registered investment advisers to maintain copies of certain books and records relating to their advisery business. Hedge fund advisers will be required to maintain these records for five years.
Compliance/Ethics – Primarily hedge funds will be required to hire or designate a chief compliance officer and adopt policies designed to prevent violation of the Advisers Act. These policies and procedures are required to be reviewed on an annual basis. Additionally, Rule 204A-1 requires SEC-registered investment advisers to adopt codes of ethics setting forth standards of conduct expected of their advisery personnel and addressing conflicts that arise from personal securities trading by their personnel, and requiring advisers’ “access persons� to report their personal securities transactions.
Proxy voting issues – Rule 206(4)-6 requires an investment adviser that votes client securities to adopt and implement written policies reasonably designed to ensure that the adviser votes in the best interests of clients, and requires the adviser to disclose to clients information about those policies and procedures. Advisers must address conflicts that may arise and policies and procedures for handling such conflicts. This collection of information is necessary to permit advisery clients to assess their adviser’s voting policies and procedures and to monitor the adviser’s performance of its voting responsibilities. This material in addition to information on how proxies were actually votes must be available and furnished to clients upon request.
Disclosure – Rule 206(4)-4 requires registered investment advisers to disclose to clients and prospective clients certain disciplinary history or a financial condition that is reasonably likely to affect contractual commitments. Hedge fund advisers will be required to disclose any material legal or disciplinary event that is pertinent to investors with respect to evaluating an adviser or choosing to remain with an adviser.
Requiring hedge fund advisers to register under the Investment Advisers Act of 1940 also establishes a fiduciary duty to clients. This fiduciary duty requires advisers to manage their clients’ portfolios in the best interest of clients. Also included is a duty to seek best execution for client transactions.