Proposed Hedge Fund Legislation

In two recent alerts, we summarized new legislation proposed in the Senate affecting hedge funds and and some of the concerns that have been raised. There is also hedge fund legislation that has been introduced in the House of Representatives. Specifically, on January 27, Representatives Michael Capuano, Democrat of Massachusetts and Michael Castle, Republican of Delaware sponsored H.R. 711, the Hedge Fund Adviser Registration Act of 2009 ("HFARA") "[t]o amend the Investment Advisers Act of 1940 to remove the registration exception for certain investment advisers with [fewer] than 15 clients." That same day, Representative Castle introduced a second bill, H.R. 713, the Hedge Fund Study Act ("HFSA") "[t]o require the President's Working Group on Financial Markets to conduct a study on the hedge fund industry."

A. H.R. 711 - HFARA

This proposed legislation is designed to remove the "Private Adviser" exemption under the Investment Advisers Act of 1940 ("IAA"), stating simply that "Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. § 80b-3) is amended by striking subsection (b)(3)." In effect, this legislation is meant to undo a 2006 court ruling that had vacated SEC efforts at requiring registration of a greater number of hedge fund advisers.

IAA Section 203 covers the registration of "investment advisers." Under IAA § 203(b), certain investment advisers are exempted from the registration requirements. Section 203(b)(3) is known as the "Private Adviser" exemption, applying to "any investment adviser who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company registered under [the IAA]."

In December 2004, the SEC adopted the hedge fund rule regarding the method for counting "clients" under Section 203(b)(3). 17 C.F.R. § 275.203(b)(3)-2. This rule provided that clients, as used in Section 203(b)(3), includes: "shareholders, limited partners, members or beneficiaries of a private fund." The hedge fund rule was a sharp contrast from the previous interpretation of "clients" as the funds themselves and meant that there would be many more hedge fund advisers that would have to register under the IAA.

The United States Court of Appeals for the District of Columbia, however, vacated the hedge fund rule in 2006 as beyond the scope of SEC rulemaking. Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). While some hedge fund advisers registered during the time the hedge fund rule was in effect and determined not to withdraw registration after Goldstein vacated the rule, hedge fund advisers that fall within the parameters of IAA § 203(b) are currently not required to register and many have not done so. The HFARA is meant to obligate more hedge fund advisers to register by repealing the "Private Adviser" exemption.

B. H.R. 713 - HFSA

In Goldstein, the D.C. Circuit commented that "'[h]edge funds' are notoriously difficult to define. The term appears nowhere in the federal securities laws, and even industry participants do not agree on a single definition." The Court recounted that the SEC had issued the hedge fund rule based on the findings of a working group of financial regulators that three shifts that had taken place with hedge funds over time. Hedge fund assets had grown substantially, an increased number of ordinary investors were investing in the funds and more fraud claims were being alleged against the funds. While these findings were made before the current financial crisis, they appear to be the basis behind renewed government efforts at wielding more control over the hedge fund industry. But it is, of course, the financial crisis and huge losses suffered by private investment funds that have ignited greater congressional interest in conducting a more thorough examination of the hedge fund industry.

If the HFSA is enacted, the President's Working Group on Financial Markets will be authorized to study:

1. the nature and characteristics defining a hedge fund;
2. the growth of hedge funds;
3. the growth of pension fund investment in hedge funds;
4. the extent to which hedge funds can protect themselves from risk;
5. the extent to which there are constraints on hedge fund leverage;
6. the extent to which hedge funds pose risks to financial markets or investors;
7. the nature and extent of international regulation of hedge funds;
8. the nature of benefits hedge funds provide to the economy and markets.

The Presidents Working Group on Financial Markets will be required to submit a report no later than 180 days after enactment of the HFSA to the Financial Services Committee of the House of Representatives and Senate Committee on Banking, Housing and Urban Affairs. That report will include:

1. any proposed legislation relating to suggested disclosure requirements for hedge funds;
2. the type of information hedge funds should disclose to the regulators and the public;
3. the efforts the hedge fund industry or financial institution regulators should undertake to improve practices or provide successful examples of initiatives;
4. the nature, degree and scope of any oversight responsibilities the President's Working Group should have over the hedge fund industry.

While Congress appears motivated to pursue hedge fund legislation expeditiously, the bills as drafted so far, raise various questions about scope of applicability and impact on other securities laws. For example, is the legislation intended just for hedge funds or for all private investment? What is the effect of this legislation on off-shore funds? What additional obligations will this legislation impose on hedge fund investors? These and other questions are certain to surface as these bills are considered within the relevant House and Senate committees.

We will continue to monitor developments and update accordingly.