����������� On July 14, 2004, the Securities and Exchange Commission (the �SEC�) voted 3 to 2 to publish proposed new rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (the �Act�) that would require most hedge fund advisers to be registered with the SEC.� The SEC also voted to publish certain proposed conforming and transitional amendments to rules 203(b)(3)-1, 204-2, 205-3, 206(4) and Form ADV.� The Commission will accept comments to the proposed new rule and rule amendments through September 15, 2004.
Before the vote, the SEC held an open meeting to discuss the recommendations of the SEC�s Division of Investment Management regarding the proposed the new rule and rule changes.� During the meeting, a number of trends in the hedge fund industry were identified by SEC Chairman William H. Donaldson and Paul Roye, director of the Division of Investment Management, as evidence of increased access to hedge funds by less sophisticated investors.� These trends include:
�������� growth of overall amounts invested in hedge funds which the SEC estimated could reach $1 trillion by the end of this year;
�������� lower minimum investment requirements imposed by many hedge funds;
�������� growth of pension plan investments in hedge funds; and
�������� �retailization� of funds of hedge funds.
Coupled with the recent market timing and late trading scandals in which hedge funds were involved, as well as an increase in the past year of enforcement actions brought against advisers of hedge funds, it was argued that the SEC �could not turn a blind eye to the risks posed to average investors by hedge funds and their managers.�
II. ������ To Whom Proposed New Rules Would Apply
����������� Under the Act, an investment adviser must be registered with the SEC unless specifically exempt from registration.� One such exemption, that the investment adviser has fewer than 15 �clients,� is relied upon by most unregistered managers.� The proposed new rules would close what Chairman Donaldson called a loophole under the current rules whereby each private fund advised by a manager be counted as a single client, and going forward require an investment adviser to look through the private funds it manages and count each investor as a client.� In addition, the proposed new rules would require an investment adviser to count each investor in a fund of hedge funds which is itself invested in the investment adviser�s private fund as a client for purposes of determining if it is exempt from registration.
Under the proposed new rules, a �private fund� is one that:
�������� would be an investment company under the Investment Company Act of 1940� but for the exceptions in Sections 3(c)(1) and 3(c)(7) of that act;
�������� permits investors to redeem their ownership interests within two years of purchase; and
��������� is offered based on the investment advisory skills, ability or expertise of the investment adviser.
The proposed new rules would contain special provisions for investment advisers located outside the United States designed to limit the extraterritorial application of the Act to offshore advisers of offshore funds that have U.S. investors.
III. ����� Requirements of Proposed New Rules
The proposed new rules would require most hedge fund investment advisers to be registered under the Act. �The SEC will propose that hedge fund managers be required to provide basic information to the SEC, including:
�������� identity of the private funds they manage and the amount of assets in these funds;
�������� information concerning their investment strategies;
�������� identity of their employees and clients;
�������� other businesses they conduct; and
�������� identity of those who control them.
Once registered with the SEC, investment advisers to hedge funds would be subject to examinations and inspections by the SEC.� Like any other currently registered investment adviser, registration would also require hedge fund managers to:
�������� adopt compliance policies and procedures designed to prevent violation of federal securities laws, including the designation of a compliance officer;
�������� maintain books and records in accordance with the rules under the Act; and
�������� provide detailed disclosure to prospective investors and current hedge fund investors of the investment adviser�s experience and disciplinary history.
IV.������ Transitional Considerations
����������� The proposed new rule and rule amendments would also include measures to help ease the transition of affected investment advisers into the new regulatory regime:
�������� records relating to the performance of hedge funds for periods prior to registration will not be subject to the more stringent record keeping rules of the Act and its rules;
�������� the �qualified client� requirement would be eliminated with respect to charging performance fees; and
�������� the new custody rules will be amended to extend the deadline for funds of hedge funds to deliver audited financials to 180 days, from the existing deadline of 120 days, from the end of a fiscal year.
V. ������ Dissenting Opinions
����������� The two dissenting Commissioners in the 3 to 2 vote made a number of arguments during the open meeting against publishing the proposed new rules for comment at this time and in their current form.� Three of their most significant arguments were:
�������� not enough time has been devoted to studying the issue and the proposed new rules contemplate a new regulatory regime before the SEC has adequately identified the scope of activity it seeks to regulate;
�������� the proposed new rules would not enhance the ability of the SEC to identify or prevent activities associated with the recent scandals involving hedge funds; and
�������� exposure of less sophisticated investors to hedge funds has been exaggerated.
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����������� It is fair to say that much uncertainty remains regarding what the final rules will look like and whether the SEC will consider the vast array of comments these proposals are likely to draw.� On the other hand, when Commissioner Paul Atkins asked Chairman Donaldson and Director Roye what types of comments would be required to change their views regarding the proposed rules, they had no answers.
����������� Please contact White & Case with any questions regarding this matter.�
David A. Goldstein
(212) 819-8757
�
Jay B. Gould, Esq.
415-544-1112 (O)
