NVCA Today

On January 29^th, Senator Chuck Grassley (Ranking Republican on the Senate Finance Committee) along with Senator Carl Levin (Chairman of the Permanent Subcommittee on Investigations of the Senate Homeland Security and Government Affairs Committee) introduced S. 344, the Hedge Fund Transparency Act.  Although Senator Grassley has introduced similar legislation previously, this is the first time that Senator Levin has joined the effort.  Neither Senator sits on the Senate Banking Committee which would have jurisdiction over this issue, but Senator Levin's role as the Chairman of the Investigations Subcommittee gives him a broad mandate.

The intent of the legislation is clear:  to ensure that the SEC has the authority to require hedge fund registration pursuant to the Investment Company Act of 1940 (ICA).  However, as analysis has surfaced about what the legislation as currently written would require, both Senators have sought to clarify their intent.

NVCA staff and Board Members, Terry McGuire and David Prend, with House Majority Leader Steny Hoyer (D-MD-5th District). This was one of the many policy meetings that occured on February 25th when the NVCA Board of Directors and members of the NVCA Medical Industry Group came to Washington, DC.

Background on hedge fund registration generally and the details of these bills are discussed below.

Background:

Venture funds, private equity firms and hedge funds historically have been excluded from regulation under the ICA because of two exemptions in the definition of investment company, usually referred to as the 3(c)1 and 3(c)7 exemptions.  The 3(c)1 exemption is intended to exclude small private investment vehicles so long as there are 100 investors or less in each vehicle and the vehicle complies with the private offering requirements of the Securities Act of 1933 (including, for example, the requirement that  investors generally must be "accredited investors" to invest in such vehicles).  Generally speaking, the 3(c)7 exemption allows an unlimited number of investors as long as all meet the higher standard of being "qualified purchasers."  Similarly, both the venture community and hedge funds have relied on an exemption to the Investment Advisers Act of 1940 (IAA) referred to as the "15 client" exemption.  That exemption states that any investment adviser who during the course of the preceding 12 months has had fewer than 15 clients and who neither holds itself out to the public as an investment adviser nor acts as an investment adviser to a registered investment company or business development company is exempt from registration under the IAA.  (Emphasis added.)

In 2004, the SEC attempted to require hedge fund registration by redefining how the number of clients must be calculated under the IAA 15 client exemption.  The new rules applied to funds that permitted an investor to withdraw its capital within 2 years of investment, thus generally excluding venture capital and private equity funds that were not hedge funds.  That effort was challenged and, in 2006, the U.S. Court of Appeals for the District of Columbia struck down the SEC's efforts in the landmark "Goldstein decision," holding that the SEC's attempt to change the 15 client exemption was arbitrary and capricious.

The Grassley-Levin bill:

The Grassley-Levin bill requires funds (not firms) with more than $50 million in assets that rely on the 3(c)1 or 3(c)7 exemptions to:

•     Register with the SEC under the ICA;

•     File an initial and annual information form which would be publicly available;

•     Maintain books and records that the SEC may require;

•     Cooperate with SEC exams or requests for information; and

•     Establish an anti-money laundering program.

Both Senators have reportedly backed away from reports that the annual information form would require the disclosure of a fund's LPs.  As reported in the Wall Street Journal, the Senators stated that:

"Contrary to some press reports, the Grassley-Levin bill to regulate hedge funds does not require the disclosure of hedge fund clients who merely invest in the fund,' the senators said.  'Instead, the bill requires disclosure of a hedge fund's beneficial owners, who profit from the fees generated in operating the fund; such ownership information has already been requested and provided on a routine basis for years in the voluntary hedge fund registrations filed with the Securities and Exchange Commission."

Even if that statement holds, NVCA will be seeking clarification that this short-form ICA registration is not also intended to mean that a fund needs to register as an investment adviser (and that other ICA ripple effects do not occur).  Also, the form requires reporting the current value of fund assets or assets under management.  While many firms already report fair value to their LPs, this is also an area that NVCA will monitor closely for clarification.

The Capuano-Castle bill:

The Capuano-Castle bill is more straightforward than the Grassley-Levin measure.  Instead of amending the ICA, the legislation targets the Advisers Act and simply removes Section 203(b)(3) - the 15 client exemption - from the Advisers Act in its entirety.  Accordingly, all firms with at least $30 million in assets under management that previously relied on that exemption would be required to register with the SEC as investment advisers.

Outlook:

The long-term chance of success for either the House or Senate bills is difficult to assess at this point.  This is very early in the legislative cycle and the committees of jurisdiction have a tremendous number of very high profile concerns on their agenda that must be addressed quickly as part of the effort to right the nation's economic ship.  However, Congress is increasing its scrutiny over many aspects of the capital markets, given the dire economic situation.