Hedge Fund Manager Registration in the Wake of Goldstein v. SEC

Paul N Roth

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• The Rule that Required Many Hedge Fund Managers to Register– In December 2004, the SEC adopted a series of rules and

amendments under Section 203 of the Investment Advisers Act of 1940 (“Advisers Act”)

– The rules (the “Registration Rule”) required hedge fund managers to “look through” their hedge funds and count hedge fund investors as “clients” unless investors were locked up for more than 2 years

– Under the Advisers Act, advisers with more than 14 clients in a 12-month period are required to register

– Managers with a non-US principal office had to register if they had more than 14 US investors in their funds

– As a result, many hedge fund managers, including European managers, had to extend lockups or register

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• Goldstein v. SEC– On June 23, 2006, the DC Circuit vacated the

Registration Rule– The DC Circuit found that the SEC’s

interpretation of the term “client” “falls outside the bounds of reasonableness”

– The order went into effect on August 18, 2006– The Registration Rule no longer exists

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• The ABA Letter to the Division of Investment Management– Because the scope of the DC Circuit order to vacate was

very broad, other unrelated portions of the Registration Rule were invalidated, perhaps inadvertently

– The vacated portions included useful clarification on registration issues

– To fill the vacuum and re-establish some interpretive guidance, the ABA Subcommittee on Private Investment Entities submitted a letter to the Division of Investment Management on July 31, 2006 (the “ABA Letter”)

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• The ABA Letter to the Division of Investment Management– The ABA Letter addressed the following areas for

advisers wishing to remain registered:• Treatment of offshore hedge fund managers to

offshore hedge funds• Books and records supporting investment performance

for periods prior to February 10, 2005• Performance compensation arrangements for periods

prior to February 10, 2005• Deadline for delivery of financial statements by funds

of funds under “custody rule”

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• The ABA Letter to the Division of Investment Management– The ABA Letter addressed the following areas for

advisers wishing to withdraw from registration:• No-action relief for withdrawing managers who fail to

file a balance sheet as part of the ADV-W• A grace period for all advisers who withdraw by or

before February 1, 2007• Confirmation that withdrawing hedge fund managers

would be able to re-establish exempt status by ceasing to “hold out” to the public and by ensuring that the number of clients advised was 14 or fewer

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• The Response of the Division of Investment Management– On August 10, 2006, the staff of the Division of Investment

Management responded to the ABA Letter– Offshore managers to offshore hedge funds may rely on

the “registration lite” regime if they remain registered– Registered hedge fund managers may continue to show

performance for periods prior to February 10, 2005 even if the supporting books and records precede their registration and do not comply with Advisers Act requirements

– Performance compensation arrangements entered into by their unregistered advisers prior to February 10, 2005 will continue to be recognized even if not in compliance with Advisers Act requirements for registered advisers

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• Response of the Division of Investment Management– Funds of funds will continue to have 180 days after fiscal

year end to deliver audited financial statements to investors under “custody rule”

– Managers that file a form ADV-W by February 1, 2007 will be able to re-establish exempt status assuming they are not “holding out” and have less than 15 clients as of the date they withdraw from registration

– Managers that file a form ADV-W by February 1, 2007 will not have to file a balance sheet as part of the ADV-W so long as there are no outstanding judgments or liens against the manager

– For managers that remain registered, the staff of the SEC reiterated that it has jurisdiction over the books and records of hedge funds managed by the adviser in addition to the adviser’s books and records

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• What to Expect Next– Many possible regulators could get involved

• The SEC

• Treasury/President’s Working Group on Financial Markets (“PWG”)

• Congress

• The states

• International Community – G8 Meeting July 2007

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• Next Steps by the SEC– On July 25, 2006, Chairman Cox testified in

Congress– On August 7, 2006, Chairman Cox issued a public

statement that the SEC would not appeal the Goldstein decision

– Both public statements by Cox indicate the following actions that will be taken by the SEC:

• The SEC will use its antifraud authority to create a new rule that “grants” hedge fund investors anti-fraud remedies against the hedge fund manager

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• Next Steps by the SEC– Both public statements by Cox indicate the

following actions that will be taken by the SEC:• The SEC will consider increasing the “accredited

investor” standard to prevent “retailization”

• The SEC will work with the President’s Working Group to develop additional regulatory oversight

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• Other Tools within SEC Jurisdiction– Direct regulation

• Possible rulemaking under broker-dealer/trading practices authority (for example, SHO) that addresses trading concerns directly

– Liberalizing advertising for registered fund managers

• 2003 Report “Implications of the Growth of Hedge Funds” included recommendation to eliminate prohibition on general solicitation/advertising by 3(c)(7) Funds

• SEC could incentivize managers to remain registered by allowing only registered advisers to advertise

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• Treasury Action/President’s Working Group on Financial Markets– On July 25, 2006 Randal K. Quarles, Under Secretary for

Domestic Finance, Treasury Department, testified before the Senate Banking Committee

– Testimony reminded Senate Committee that hedge funds provide important benefits to the markets

– Treasury and PWG continue to monitor for systemic risk– Many risks attributable to hedge funds are not unique to

hedge funds

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• Treasury Action/President’s Working Group on Financial Markets– PWG is “encouraged” by efforts in credit risk

management taken to date– PWG does not recommend direct regulation of

hedge funds– Treasury is currently examining whether hedge

funds and “other phenomena” such as derivatives and alternative investments, have the potential to change overall level of risk in markets and financial institutions

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• Possible Congressional Action– On September 27, 2006, the House of Representatives passed

H.R. 6079, the “Hedge Fund Study Act”– H.R. 6079, if passed by Congress, would require the following:

• Require PWG to submit a report on the hedge fund industry, its investors, and potential market risks of hedge fund investment strategies 180 days after passage of the Act to the Committee on Financial Services (House) and the Committee on Banking, Housing, and Urban Affairs (Senate)

• Include recommendations on the following topics:– any proposed legislation regarding hedge fund disclosure– the types of information hedge funds should disclose to regulators and

the public– “best practices” for the industry and for regulators of the industry– whether PWG should have oversight over the industry and the degree

and scope of such oversight

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• Possible Congressional Action– Barney Frank (MA) has introduced legislation to

restore “look through” to underlying investors– Chuck Hagel (NB) has asked for Congress to

review level of appropriate oversight– Senate Banking Committee held a hearing on

July 25, 2006 whether Congressional action would be needed

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• Possible Steps by the States– SEC jurisdiction preempts states only when

manager is registered with the SEC– Managers relying on SEC exemption may still be

subject to state anti-fraud actions– Some states may look to “fill the vacuum” left by

the Goldstein decision

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• International Action?– Germany has called for the G8 to review hedge

fund transparency in July 2007– Despite US/UK reticence, hedge fund regulation

may be a topic of discussion at the G8

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• Are Advisers Deregistering?– Industry at Large

• As of September 25, 2006 70 hedge fund managers have withdrawn by citing the overturn of Goldstein as its reason for de-registration. 2,549 funds remain registered.

• According to August, 2006 Greenwich Associates research of 47 fund managers interviewed, 30% had increased staffing to comply with Registration Rule, 27% would stay registered, 55% were uncertain whether to remain registered, and 20% plan to deregister

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• Should We Deregister?– Factors against deregistration

• Regulatory uncertainty• Sunk compliance costs have already been paid• Compliance standards are becoming industry “best

practices”/SEC sets the standard• Registered status may have been used in

marketing/soliciting investors• ERISA and institutional money seek out registered

investment advisers

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• Should We Deregister?– Factors in favor of deregistration

• Inspectors continue to be unpredictable

• Managers with few employees may find day to day compliance burdens onerous

• Maintenance of compliance records will cost resources

• Incremental rules applicable only to registered advisers (solicitation rule; qualified client requirement)