In prior posts, The Race to the Bottom has discussed the growth, influence, and lack of regulation of hedge funds. Similar discourse occurred on the Harvard Corporate Governance Blog and the Wall Street Journal. On January 29, 2009, Senators Carl Levin (D-MI) and Chuck Grassley (R-IA) introduced The Hedge Fund Transparency Act. This post discusses how the bill is a reaction to previous hedge fund regulation.
Hedge funds are typically structured to avoid the strictures of the Investment Company Act of 1940. As a result, hedge funds do not typically register with the SEC. Unlike most mutual funds and other investment companies, there is little public information about hedge funds. In 2004, the SEC, concerned over itslack of control, proposed The Hedge Fund Rule.
Rather than focus on the funds, the SEC instead opted to regulate hedge fund advisers. Hedge fund advisers mostly avoided registration by relying on the exemption for advisers with fewer than 15 clients. Hedge funds only counted as one client. Under the Hedge Fund Rule, however, an adviser of a "private fund" was required to count as clients all of the owners of the "private fund." Private fund, in turn, applied to investment companies that would be subject to registration except for the exemption for funds with fewer than 100 owners, that allowed redemptions within the prior two years, and marketed the investment based on their skill.
By requiring registration of the adviser, the SEC's approach promised to provide hedge fund investors with the protections of the Investment Adviser's Act. In addition, the registration requirement would have added a higher degree of transparency to the activities of hedge funds and their advisers.
The DC Circuit Court in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006), however, struck down the Hedge Fund Rule, finding that it exceeded the SEC's rulemaking authority. The court focused on how the Hedge Fund Rule expanded the term“client” to include the owners of the hedge funds. Since the adviser's duties ran to the fund, not to the investors, the court viewed the interpretation as inconsistent with the statute and unreasonable.
As a result of the decision, hedge funds remained mostly unregulated. With little SEC oversight, hedge funds became more influential on the market as their assets expanded. Hedge funds in 2004, had 7.4 trillion dollars in assets, by 2007 they had amassed 10.7 trillion dollars in assets.
The Hedge Fund Transparency Act, if implemented, goes beyond the SEC's Hedge Fund Rule. Funds with more than $50 million in assets, regardless of the number of clients, must file with the SEC. Funds must disclose: the number of investors, the names and addresses of natural persons who are beneficial owners, the structure of ownership, and the current value of the fund. The legislation focuses on the fund, instead of the advisers, avoiding the conflicts between an adviser, the fund, and its investors. The legislation also requires the SEC to develop rules for an anti-money laundering program that hedge funds, regardless of asset value, will have to implement.
The bill is still working its way through the legislative process, subject to change and amendment. In its current form, the legislation expands the SEC’s regulation of hedge funds.