Reshaping the Global Hedge Fund Industry
By: Edward G. Eisert, Megan B. Munafo
Hedge funds are under intense scrutiny as a result of the global financial crisis and the most comprehensive review of the financial industry regulatory framework in 70 years. Until recently, most legislators and regulators believed that the hedge fund regulatory regime was adequate, taking into account reliance on the oversight of hedge fund financial counterparties, such as prime brokers. However, in the current environment, anxiety has grown that hedge funds could pose a systemic risk to the global financial system due, in part, to: (i) the large amount of assets managed through hedge funds; (ii) the use of leverage by hedge funds; (iii) the relative lack of transparency concerning their operations; and (iv) the limited power of regulators to examine their managers and the funds themselves.
Although hedge funds have been a focus of regulatory reform in the past, global initiatives have accelerated in 2009. In the wake of the April 2009 G-20 meeting held in London, two sets of initiatives are anticipated to significantly reshape the regulation of hedge funds: (i) the draft Directive on Alternative Investment Fund Managers (“AIFMs”) issued by the European Commission; and (ii) legislative developments in the United States.
Draft Directive Issued by the European Commission
On April 29, 2009, the European Commission proposed legislation designed to impose the first European-wide regulation of alternative investment capital pools, including hedge funds, in an effort to reduce systemic risk and harmonize regulation in the European Union (“EU”). The proposed Directive on Alternative Investment Fund Managers (the “AIFM Directive”) would require EU-domiciled managers of hedge funds and other alternative capital pools with assets under management of more than €100 million, or €500 million where the funds have “no leverage” and a “lock-up period” of five years or more, to be “authorized” by their home Member State and report regularly on the main investments of the fund, its performance and risks. In addition, AIFMs would be subject to ongoing regulation relating to minimum capital, risk management and audit arrangements. (Directive of Alternative Investment Fund Managers (AIFMs): Frequently Asked Questions, Memo/09/211, 29/04/2009).
The AIFM Directive would not regulate the fund itself, its fees, or its investment objectives. Rather, the AIFM Directive provides that: (i) only AIFMs established in the EU can provide their services in the EU; and (ii) only funds domiciled in the EU can be marketed by authorized AIFMs in the EU. Nonetheless, in order to allow offshore funds to continue to be offered in the EU, the AIFM Directive would provide an “EU Passport” for the marketing of such funds that comply with “stringent requirements in regulations, supervision and cooperation, including on tax matters.” The AIFM Directive would impose for the first time capital requirements on AIFMs and limits on fund leverage, and it would also establish business conduct principles such as fair dealing and detailed rules regarding independent valuation and disclosures to investors and reporting to regulators. The AIFM Directive would also institute reporting requirements regarding controlling interests in fund portfolio companies. In order to allow time for the development of rules allowing for the marketing of “third country funds,” for a period of three years after the effectiveness of the AIFM Directive, third country funds could continue to be sold in the EU, subject to individual Member State approval. In light of the strong critical reaction by various organizations in the alternative investment industry, and the requirement that the AIFM Directive is subject to approval by the European Council and the European Parliament, it is not likely to become effective until at least 2011. For more information on the proposed Directive, please see the K&L Gates Alert “European Commission Proposes Regulation of Alternative Investment Fund Managers.”
U.S. Legislative Developments
In the first quarter of 2009, several bills were introduced in the U.S. Congress that would require hedge fund managers and “large” hedge funds to register with the U.S. Securities and Exchange Commission (“SEC”), comply with information reporting and other requirements, and subject them to further study. One, the “Hedge Fund Transparency Act,” would limit the availability of the exemptions from registration under the Investment Company Act of 1940 relied upon by hedge funds to those with assets under management of less than $50 million. (S. 344, 111 th Cong. (2009)). Another, the “Hedge Fund Adviser Registration Act of 2009,” would eliminate the “private adviser exemption” under the Investment Advisers Act of 1940 (the “Advisers Act”), commonly relied upon by hedge fund managers, with the effect of requiring virtually all hedge fund managers to register with the SEC under the Advisers Act. (H.R. 711, 111th Cong. (2009)). Although its precise terms have not yet been defined, following the G-20 meeting in April and the increased focus on a global systemic risk regulator, a broad legislative proposal is anticipated in 2009 that will include a requirement that private fund managers be registered under the Advisers Act. The Obama Administration has also proposed that the SEC be authorized to obtain, among other things, hedge fund portfolio holdings information from fund managers in order to report on potential systemic risks to a newly designated systemic risk regulator.
In May 2009, in testimony at a hearing held before the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, the Managed Funds Association (the “MFA”) announced its support for the mandatory registration of investment advisers (including advisers to private pools of capital) with the SEC under the Advisers Act. The MFA is an organization comprised of professionals from hedge funds, funds of funds, managed futures funds and industry service providers. The proposed framework supported by the MFA goes beyond recent proposals, which only sought to require the largest fund advisers to be registered, and would subject the vast majority of investment advisers to the registration requirements of the Advisers Act. The MFA’s position signals that leading hedge fund managers have accepted that there will be increased regulation and are trying to shape it rather than fight it.
Also of far-reaching impact, the President’s Budget Outline for fiscal year 2010 includes provisions for the taxation as ordinary income of the “incentive allocation” or “override” received by the managers of U.S.-domiciled hedge funds. As proposed, the “Stop Tax Haven Abuse Act” would “restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid federal taxation, and for other purposes.” (S. 506, 111 th Cong. (2009); H.R. 2136, 110 th Cong. (2007)). At the same time, the Treasury has reaffirmed the value of private pools of capital to the financial system in its proposals for Public-Private Investment Funds.
Moving Forward
As these various initiatives progress, it appears that not only will private investment fund managers, wherever domiciled, become subject to more intense U.S. regulatory scrutiny, but U.S.-domiciled managers will become subject to EU regulatory scrutiny, at least insofar as they manage European-based funds or market funds in Europe. An active, substantive dialogue between the private sector and global regulators will be necessary in order to promote the development of regulatory reforms that are measured and that contribute to the restoration of financial market stability without unduly restricting the ability of hedge funds to meet the needs of investors.
