LEGISLATIVE UPDATE: THE HEDGE FUND TRANSPARENCY ACT

Executive Summary

 

            In late January 2009, two senior U.S. Senators introduced the Hedge Fund Transparency Act (“HFTA”),[1] which would require a wide variety of private investment funds—not just hedge funds—with assets (or assets under management) exceeding $50 million to register with the SEC.  Such registration as an “investment company” under the Investment Company Act of 1940 would be mandatory for all private funds that rely on two widely-used exemptions from registration and regulation under this Act.  Registration would require the provision of a significant amount of information relevant to an investor’s decision to invest in a private investment fund.  In addition, the bill contains other provisions, most notably requiring each private fund to create an anti-money laundering (“AML”) program.

 

            It is important to note that registration and the related provision of information would not result in full regulation under the Investment Company Act of 1940.  However, enactment of the HFTA or similar legislation would create many other issues including potential violation of confidentiality agreements between private funds and investors and regulation under other securities laws.

 

Proposed Registration Framework for Private Funds

 

            Currently, private investment funds generally rely on two exemptions from regulation under the Investment Company Act of 1940: (1) Section 3(c)(1) (for investment vehicles held by no more than 100 beneficial owners and that are not offered publicly) or (2) Section 3(c)(7) (for investment vehicles held exclusively by “qualified purchasers” and that are not offered publicly). The proposed HFTA deletes these two Sections and replaces them with new Sections 6(a)(6) and 6(a)(7) without substantive change. This change is designed to make it clear that a private fund is an “investment company” [2] for purposes of the Investment Company Act.  However, private investment funds falling under these two Sections would generally be exempted from the substantive provisions of the Act.

 

            Instead, the HFTA requires a fund that has assets (or assets under management) of $50 million or more to meet several conditions to fall within the exemptions:

 

• The fund must register with the SEC;

• The fund must maintain such books and records as the SEC may require;

• The fund must cooperate with any request for information or examination by the SEC; and

• The fund must file an information form (“Information Form”) to be prescribed by the SEC;

 

The Information Form would be electronically filed at the times required by the SEC, but at least every 12 months, and would be publicly available in an electronic searchable format.  The Information Form would include the following information:

 

• The name and address of (i) each natural person who is a beneficial owner of the fund, (ii) any company with an ownership interest in the fund, and (iii) the fund’s primary accountant and primary broker;

 

• An explanation of the structure of ownership interests in the fund;

 

• Information on any affiliation that the fund has with another financial institution;

 

• A statement of any minimum investment commitment required of investors;

 

• The total number of investors; and

 

• The current value of (i) the assets of the fund and (ii) any assets under management by the “investment company.”

 

Within 180 days of enactment of the HFTA, the SEC would be required to issue rules, forms, and guidance to implement the law.

 

Proposed Anti-Money Laundering Program

 

            A separate portion of the HFTA would require all investment funds subject to SEC oversight to establish AML programs similar to those used by other financial institutions under the Bank Secrecy Act.  Under the HFTA, the Treasury Department, in consultation with the SEC and the CFTC, would be required to adopt a rule within 180 days that would require private funds to use risk-based due diligence policies, procedures, and controls.  Such a program would have to be reasonably designed to ascertain the identity of and evaluate any foreign person (including, where appropriate, the nominal and beneficial owner or beneficiary of a foreign corporation or other entity) that provides, or plans to provide, funds to be invested with the advice or assistance of the investment company.

 

Finally, all private investment funds—regardless of whether they have more or less than $50 million in assets (or assets under management)—will be subject to AML requirements.

 

Important Observations

 

            While it is unclear whether, when, and how much of the HFTA will advance in the Senate—particularly because neither of the co-sponsors sits on the Senate Banking Committee—it is clear that Congress remains serious about opening access to information about private investment funds.  Using the HFTA as a backdrop, important questions need to be asked in advance of such legislation:

 

• The HFTA inquires into the investors in private investment funds versus the managers and investments of the private investment funds.[3]  So be conscious that Congress may be indicating that it wants the SEC to be able to pry as much as possible—even if it has no effect on regulating systemic risk or protecting investors.

 

• Equally proprietary for venture capital, private equity, and other private funds is the valuation of their investments.  But the proposed HFTA could very well turn into a vehicle that requires public disclosure of information concerning how valuations are calculated.

 

• The HFTA does not provide any guidance regarding the treatment of confidentiality agreements between private investment funds and their investors.  If the HFTA were enacted into law in its current form, private investment funds would apparently be required to breach these agreements unless they contain applicable exceptions for legally required disclosures.

 

• If your private investment firm is already registered as an adviser under the Investment Advisers Act of 1940, then the registration provision of the HFTA may have little or no effect on you. However, if your firm is currently exempted from registering as an adviser under the Section 203(b)(3) “private adviser”[4] exemption, it appears as though you will have to register if the HFTA becomes law. 

 

• Other exemptions to the Investment Company Act of 1940 would still remain.  For example, funds not issuing redeemable securities that are primarily engaged in purchasing or otherwise acquiring mortgages and other liens/interests in real estate would still be exempt from registration.  Thus, the HFTA bill may induce larger, private investors to move into the real estate or other markets where they can maintain their anonymity.

 

• The HFTA is silent in terms of defining “assets” and “assets under management.”

 

• The Foreign Corrupt Practices Act[5] accounting provisions would not apply to private investment funds under the HFTA.  However, other provisions, such as the anti-bribery provisions, would still apply. 

 

Please contact Steve Sims or David Seidman at Enterprise Law Group at 312-578-0200 if you have any questions about the proposed Hedge Fund Transparency Act or other securities law issues.