South Carolina BAR Journal
SC Lawyer, November 2011, #3.
Financial Regulatory Reform Imposes New Requirements on Investment Advisers and Hedge Funds
South Carolina LawyerNovember 2011Financial Regulatory Reform Imposes New Requirements on Investment Advisers and Hedge FundsBy William J. Condon Jr. A large number of individuals and institutions use investment advisers to manage their assets and invest a significant amount of money in alternative investments, including hedge funds. These individuals and institutions may ask their attorney for advice either when an investment is first made or after an investment fails. It is important for attorneys to know the legal framework under which these investment advisers and hedge funds operate, and significant changes to this legal framework were recently enacted.
In response to the financial crisis of 2008, Congress passed and on July 21, 2010, President Obama signed a financial regulatory reform bill titled the "Dodd-Frank Wall Street Reform and Consumer Protection Act" (Dodd-Frank). The bill was sweeping and included high-profile changes, including the creation of a new Financial Stability Oversight Council (the Council) to oversee systemic risks in the economy, the supervision of certain nonbank financial companies by the Board of Governors of the Federal Reserve, the appointment of the Federal Deposit Insurance Corporation to act as receiver for certain financial companies, the imposition of increased oversight of derivatives and the creation of the new Bureau of Consumer Financial Protection. In addition to these high-profile changes, Dodd-Frank in Title IV-Regulation of Advisers to Hedge Funds and Others-imposes the first significant regulation on hedge funds and their investment advisers and imposes other changes on investment advisers.
In addition to the financial crisis of 2008, a couple of other factors were primarily responsible for the increased and changing regulation of hedge funds and investment advisers. First, Congress, the U.S. Securities and Exchange Commission (SEC) and others had long been skeptical of the unregulated nature of hedge funds. In most instances, neither the securities sold by hedge funds, see 15 U.S.C. 77d (2010), nor the fund itself, see 15 U.S.C. 80a-3(c)(1), (7) (2010), nor the investment adviser that managed the hedge fund, see 15 U.S.C. 80b-3(b)(3) (2010) (repealed 2010), had to be registered under federal securities laws. Because of these exemptions from registration, no one knew the size and scope of the hedge fund industry or the investment strategies and investment positions held by individual hedge funds. SeeGoldstein v. SEC,451 F.3d 873, 875-76 (D.C. Cir. 2006). Second, in December 2008, Bernard Madoff, who ran an investment advisory firm that allegedly managed billions of dollars of assets, admitted to defrauding clients and was charged with securities fraud. The total amount of Madoffs fraud approximates $15 billion to $20 billion. This scandal gave Congress the leverage to finally impose significant regulations on the hedge fund industry.
In addition to the new regulation of hedge funds and their advisers, Dodd-Frank imposes new laws on investment advisers in general. The most talked about change is the shift in regulation of many mid-sized investment advisers from SEC oversight to state oversight. Because the SEC did not uncover the Madoff fraud after it received several warnings of the fraud, Congress was concerned that the SECs resources had been stretched too thin. Dodd-Franks shift of the responsibility to regulate mid-sized advisers from the SEC to state securities regulators will supposedly help the SEC use its scarce resources to regulate large hedge funds and other systemic risks in the economy.
The new laws imposed upon hedge funds and investment advisers were to become effective on July 21, 2011, unless otherwise provided. Dodd-Frank Wall Street Reform Consumer Protection Act, H.R. 4173, 111th Cong. 419 (2010).
In Dodd-Frank, Congress used and defined the term "private fund." See 15 U.S.C. 80b-2(a)(29) (2010). The term "private fund" means an issuer of securities that would be an investment company as defined in the Investment Company Act of 1940, but for section 3(a)(1) or 3(a)(7) of that Act. Id.
A private fund is essentially an investment company that does not have to register as an investment company. Private funds and registered investment companies both accept investors money and invest it on a collective basis. An example of a registered investment company with which many people are familiar is a mutual fund, which investors use in a 401(k) retirement account or in other retirement and non-retirement accounts. Mutual funds are highly regulated because they have to register with the SEC as an investment company...