Financial Reform Bill and Hedge Funds

June 27, 2010

The House and Senate Conference Committee on Friday finished reconciling the two versions of the financial reform bill and some of the major items are going to affect the hedge funds.  Over the next week and a half we are going to hear more about the details of the bill and how the financial landscape will change in the coming months and years.  In this article, we are going to briefly detail the hedge fund registration requirement.

Hedge Fund Registration

The biggest issue for most managers will be the elimination of the current 203(b)(3) hedge fund registration exemption.  Under the new laws, hedge fund managers with assets under management of $100 million or more will be required to register with the SEC.  Additionally, these managers will be required to provide the SEC with certain information related to their trading.  While managers may already be subject to Section 13(d)/Section 13G and Section 13(f) filings, the scope of the information required under the reform bill is likely to be much greater.

Managers subject to the registration requirement will need to be registered within one year of the enactment of the bill (expected to be July 4th or sooner).  Because of the large number of expected applications, managers are urged to begin the registration process as soon as possible to avoid any unnecessary delays to their business and ensure smooth transition to registration.

Increased State Authority over Funds

The bill increases the threshold for registration with the SEC.  Currently managers who have at least $30 million in AUM can register with the SEC.  After the bill goes into effect, that number increases to $100 million.  This means that some managers currently registered with the SEC will have to de-register and then register with the state where the manager resides.

This is a controversial because many of the state securities divisions do not have the budget or staff to deal with an increase in oversight.  With many states currently facing budget shortfalls, this is potentially the worst time to saddle already underfunded state divisions with additional oversight responsibility.

Potential Increased Oversight by Federal Agencies

There are two new federal agencies which potentially could be involved in with further regulation of hedge funds: the Consumer Financial Protection Bureau and the Financial Stability Oversight Council.  These agencies have fairly broad mandates which may give them the authority to regulated hedge funds.

The Financial Stability Oversight Council in particular has the ability to either regulate or break up certain financial companies is there are potential negative effects on the financial system.  Very large hedge fund managers could easily face such regulation.

OTC Derivatives

The regulation of the OTC derivatives markets have been a tough issue and it is not clear exactly how it will play out. At least some OTC derivatives will be required to be cleared through an exchange – both the SEC and CFTC will have jurisdiction over the contracts and are tasked with naming the contracts to be exchange traded.  Because of the complex nature of clearing these instruments, and because financial institutions could simply engage in such trading in unregulated offshore markets, this issue will be studied carefully by the SEC and CFTC before any final regulations are promulgated.

Accredited Investor Standard Increased

The bill would initially adjust the accredited investor standard and then require periodic adjustments over time. Initially, an investor’s equity in a primary residence will no longer count toward the $1 million net worth requirement. On a periodic basis the SEC will be required to adjust the net worth requirement.  While this will not generally affect large hedge funds (which require investors to be qualified purchasers, a higher standard), it will negatively impact smaller hedge funds who have investors with relatively smaller net worths.  This will not only affect small hedge fund managers, but it will also affect all small companies who rely on accredited investors for investments.

What’s Next?

After the bill is signed into law by President Obama, the SEC will go to work immediately to begin planning the implementation process for many of the new laws.  There are also a number of items on which the SEC will be seeking public comments.  There are also likely to be new regulations proposed by the SEC to provide guidance on the new laws.

After regulations have been proposed and enacted, the SEC will likely need to provide supplementary guidance. During this process attorneys and compliance personnel will be discussing the ways in which hedge funds will need to modify or expand their activities in order to comply with the new laws and regulations.

About the Author

Bart Mallon, Esq., of Mallon P.C., provides comprehensive hedge fund start up and registration services.  Mr. Mallon can be reached directly at 415-868-5345.

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