The Way Forward
CPIC is a strong supporter of the SEC, its dedicated staff, and its mission. But increased regulation and government supervision does not always bring increased protection for investors or support economic growth. Before the 2007–2009 economic downturn, some observers predicted that hedge funds and other private pools of capital would be the source of the next financial crisis, because these investment vehicles are not as heavily regulated as other financial firms. However, the greatest harm to investors and the global economy actually came from comprehensively regulated institutions like banks, insurance companies, broker-dealers, and government-sponsored enterprises. While under direct regulatory supervision, examination, and enforcement, these heavily regulated organizations piled on debt and both made and securitized unsound loans beyond all reason, creating a massive credit bubble that finally burst.
Simply imposing new regulation without properly tailoring it to address the relevant risks would add to the burdens of hard-working, but already overstretched government agency staffs. Investors could be lulled into the false belief that a problem has been resolved. Therefore, any new regulation must be “smart” regulation, with mechanisms carefully targeted to reduce risks to investors and the economy, without imposing unnecessary burdens.
CPIC recognizes that a modernized financial regulatory system—one that addresses overall risk to the financial system and regulates in a consistent manner market participants performing the same functions—will include regulation of hedge funds and other private pools of capital. These policy discussions should be guided by the following principles:
- Any new regulations should treat all private investment funds similarly, regardless of the fund manager’s investment strategy.
- The Investment Advisers Act and the Investment Company Act are awkward statutes for achieving the policy objectives of increased private investment fund oversight. Congress should consider drafting a new statute that clearly spells out a preferred means of improving oversight without degrading investor due diligence, stifling innovation, reducing market liquidity, or harming global competitiveness.
- New regulation should draw upon the best practices work of the President’s Working Group Asset Managers and Institutional Investors Committees; their reports provide many specific improvements carefully crafted for the unique nature of private investment companies.
- Regulation for systemic and market risk should be scaled to the size of the entity, with a greater focus placed on the largest funds or family of funds.
In July 2009 testimony before the Senate Banking Subcommittee on Securities, Insurance, and Investment, CPIC outlined the case for a new statute specifically tailored to private investment companies. Neither the Investment Company Act nor the Advisers Act in its current form is the ideal tool for the job of regulating hedge funds and other private investment companies. They do not contain the provisions needed to address the potential risks posed by the largest large private investment companies, the types of investments they hold, and the contracts into which they enter. At the same time, those laws each contain provisions designed for the types of businesses they are intended to regulate—laws that would either be irrelevant to oversight of private investment companies or would unduly restrict their operation.
Many of the elements of such a statute should be similar to provisions currently in the Advisers Act or Investment Company Act, but others would be tailored to private investment funds. Such a new statute could be codified as a new Section 80c of Title 15 of the US Code. (Section 80a is the Investment Company Act, while Section 80b is the Investment Advisers Act) and should apply to private investment funds of all kinds with assets under management of more than $30 million, no matter whether a fund is called a “hedge,” “venture capital,” “private equity” or other type of fund. They should also include all foreign investment companies that conduct U.S. private offerings, so that a fund would gain no benefit by organizing or operating as an “offshore” entity. Private funds subject to the new statute would not be subject to registration under the Investment Company Act if they continue to meet the standards for exclusion under Sections 3(c)(1) or 3(c)(7)120 or other relevant exemption, nor would they be subject to registration under the Advisers Act if they continue to meet the requirements for exemptions under that act. They would, however, be required to register under the new “Private Investment Company Act” and be subject to its provisions. Registration—whether under the Advisers Act or under a new “Private Investment Company Act”—will bring with it the ability of the SEC to conduct examinations and bring administrative proceedings against registered funds and their personnel. The SEC also will have the ability to bring civil enforcement actions and to levy fines and penalties for violations.
CPIC’s proposal includes provisions to:
- Reduce the risks of Ponzi schemes and theft. Money managers would be required to keep client assets at a qualified custodian, and by requiring investment funds to be audited by independent public accounting firms that are overseen by the Public Company Accounting Oversight Board (PCAOB).
- Extend custody requirements to all investments held by covered funds. Fund assets should be held in the custody of a bank, registered securities broker-dealer, or (for futures contracts) a futures commission merchant. A fund’s annual financial statements should be audited by an independent public accounting firm that is subject to PCAOB oversight.121 While the SEC has adopted custody rules for registered advisers pursuant to its anti-fraud authority under the Advisers Act (and recently proposed amendments to those rules), we believe Congress should provide specific statutory direction to the SEC to adopt enhanced custody requirements for all advisers.
- Require specific disclosures by private investment funds to investors and counterparties. The proposal would require private investment funds to provide potential investors with specific disclosures before accepting any investment, and provide existing investors with ongoing disclosures.122 Among other things, a private fund should be required to disclose in detail its methodologies for valuation of assets and liabilities, the portion of income and losses that it derives from Financial Accounting Standard (FAS) 157 Level 1, 2, and 3 assets,123 and any and all investor side-letters and side-arrangements. Likewise, private funds should have to disclose the policies of the fund and its investment manager as to investment and trade allocations. They should also disclose conflicts of interest and financial arrangements with interested parties, such as their investment managers, custodians, portfolio brokers, and placement agents. Funds should also be transparent with respect to their fees and expense structures, including the use of commissions to pay broker-dealers for research (“soft dollars”). Investors should receive audited annual financial statements and quarterly unaudited financial statements. These recommendations are consistent with those from the Administration.
- Establish requirements for large funds, family of funds and/or its manager. The proposal considers establishing a gross assets threshold (e.g., $500 million). For example, larger funds should be required to adopt a code of ethics and a proxy voting policy, implement written supervisory and compliance procedures, designate a chief compliance officer, and implement disaster recovery, business continuity, and risk management plans to identify and control material operational, counterparty, liquidity, leverage, and portfolio risks.124 In addition, such a fund should be required to adopt a detailed plan to address liquidity and for conducting an orderly wind-down that assures parity of treatment of investors in the event of a major liquidity event.
- Require customer identification and anti-money laundering programs. Private investment companies would have to file suspicious activity reports and currency transaction reports, just as securities broker-dealers are required to do.125
- 120. Certain family-owned companies that are deemed “qualified purchasers” pursuant to Section 2(a)(51)(A)(ii) or (iii) of the Investment Company Act should not be covered by the new requirements, however. Companies, trusts and estates etc., that are owned by members of one family and that own investments should not be deemed to be investment companies or regulated like other private investment funds.
- 121. This requirement is consistent with the AMC Best Practices, and would close the above-described gaps in the protections provided by the Advisers Act custody rule. Chanos, July 15, 2009 testimony, op. cit., footnote 6.
- 122. This requirement is consistent with the AMC Best Practices.
- 123. See n. 15 supra.
- 124. These requirements are consistent with the AMC Best Practices.
- 125. This requirement is consistent with the AMC Best Practices.