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Hedge Fund Industry Comments to SEC on Host of Commission Initiatives under Dodd-Frank

By Jim Hamilton

The hedge fund industry has commented to the SEC on a host of Commission initiatives under the Dodd-Frank Act involving both rulemaking and studies. Broadly, in its letter to the SEC, the Managed Funds Association asked the Commission to consider the appropriate regulatory framework for hedge fund and private investment fund advisers against the backdrop of a hedge fund industry that, while important to the capital markets, is relatively small in size and scope when considered in the context of the wider financial market landscape. Similarly, although hedge funds are often characterized as being highly leveraged financial institutions, the fact is that they have been significantly less leveraged than other financial market participants.

More specifically, the MFA noted that Section 416 of the Dodd-Frank Act requires a GAO study on the feasibility of a self-regulatory organization to oversee private investment funds. Similarly, Section 914 requires the SEC to study the need for enhanced examination and enforcement resources for investment advisers, including whether designating an SRO to oversee advisers would improve the frequency of examinations of advisers. The hedge fund industry opposes an SRO for investment advisers based on its belief that SRO regulation would subject advisers to potentially duplicative or inconsistent requirements without any countervailing public benefit. The industry is also concerned, given the significant variation in business models among investment advisers, that a single SRO for investment advisers would be ill-equipped to handle the diversity of issues without being cost prohibitive.

Section 403 of Dodd-Frank provides that an adviser to a private investment fund that is also a CFTC-registered commodity trading advisor is exempt from registration with the SEC unless the business of the adviser should become predominantly the provision of securities-related advice. In the MFA?s view, the legislative intent of Section 403 is that CTAs to private investment funds, which are already subject to a comprehensive regulatory framework, do not have to be dually registered. It further reflects the view that requiring these CTAs to register with both the SEC and the CFTC would subject them to a duplicative regulatory framework and potentially inconsistent regulations. Thus, the MFA encouraged the Commission and the CFTC to adopt guidance clarifying the criteria relevant to determining whether an investment adviser or a CTA that is registered with one of the agencies can rely on the relevant exemption from registration with the other agency, respectively.

Section 404 of Dodd-Frank authorizes the SEC compel reporting by private investment fund advisers of highly sensitive and proprietary information for systemic risk purposes, while at the same time providing for confidential protection of proprietary information reported by private investment fund advisers. Deeply concerned about the prospect of proprietary information being disclosed to the public, the MFA urged the SEC to put in place strong confidentiality safeguards protecting the proprietary interests of private fund advisers, and that the safeguards continue to exist when the Commission shares such information with other regulators.

Section 956 of the Dodd-Frank Act requires federal regulators to establish rules or guidelines that would require covered financial institutions to disclose to regulators any incentive-based compensation arrangements, and would prohibit an institution from enacting any incentive-based compensation arrangements that encourage inappropriate risks. Since sophisticated investors choose to invest in hedge funds to diversify their portfolio and because of the alignment of interests that results from the link between the profits of the investor and the compensation of the adviser, the MFA reasoned that any rules prohibiting incentive-based compensation under Section 956 would be inappropriate in the private investment fund context and could harm investors.

The focus in implementing Section 956 should be to address incentive-based compensation arrangements by firms that could create risk to the financial system or to taxpayers. For private investment fund advisers that do not have either public shareholders or federally insured deposits, and do not otherwise jeopardize the financial system, said the MFA, there is no public interest in restricting the compensation structures with respect to such advisers.

Section 929R of Dodd-Frank Act authorizes the Commission to shorten the time period during which a beneficial owner of more than 5% or 10% of a class of equity securities must report its ownership. Currently, each section requires a beneficial owner to report its ownership within ten days after the acquisition. The reporting obligations provided in Section 13(d) and Section 16(a) of the Exchange Act are designed to both encourage investment activity and provide shareholders with notice of material changes in ownership, noted the MFA, and the existing ten-day should be preserved since it strikes the appropriate balance between these two important objectives.

Under Section 913 of Dodd-Frank, the SEC may adopt a new standard of conduct for investment advisers providing investment advice to retail clients, and potentially other types of clients. For more than forty years, the Commission has brought enforcement actions against investment advisers for violations of their fiduciary duty to clients under Section 206 of the Advisers Act. The Commission has broadly interpreted the scope of an adviser?s fiduciary duty to apply to all aspects of an adviser?s management of client assets. In the MFA?s view, these standards of conduct have created certainty in the markets, hav e functioned effectively for many years, and are an integral part of how investment advisers conduct their businesses. Thus, the MFA urged the SEC not to needlessly uproot a widely-accepted standard upon which investors and investment advisers have relied for many years.

Full post as published by Jim Hamilton's World of Securities Regulation on November 01, 2010 (boomark / email).