The recent global financial crisis prompted a far reaching legislative and regulatory response, the most notable of which was the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).1 Much has been written concerning the cause of the crisis and efforts to reduce future systemic risks to the financial system. By and large, the investment management business (investment advisers, mutual funds, exchange traded funds, hedge funds and private equity funds) did not play a significant role in bringing the crisis about, and as a result, the vast bulk of reform efforts have focused away from the investment management business.2
However, the wave of reform following the financial crisis did not entirely miss the investment management industry. In this article, we will focus on four significant reform efforts, some completed, some still a work in progress, that have directly targeted funds and their advisers. These four initiatives are: 1) money market fund reform, 2) registration requirements for hedge fund advisers, 3) higher net worth requirements for clients who are charged performance fees by their advisers and for investors in hedge funds, and 4) Commodity Futures Trading Commission (CFTC) regulation of investment advisers managing mutual funds that are deemed to be functioning as "commodity pools."3
Money Market Fund Reform
There has been much debate about the role that money market funds played in the financial crisis and the continued risk these funds may or may not pose to the financial system.4 Unlike other types of investment companies, money market funds are structured so as to attempt to maintain a stable, $1 per share, net asset value.5 Money market funds are a popular investment choice for investors and financial institutions with short-term investment needs, such as the need to invest overnight cash balances. Many investors also use money market funds as checking accounts. Money market funds are required to invest only in certain short-term high quality debt instruments, and as a result they provide an important source of financing for many corporations and for state and local governments and municipalities, who rely on money market funds as buyers of their commercial paper and short-term debt instruments.6
In the immediate aftermath of the default of Lehman Brothers, a prominent money market fund, the Reserve Fund, which had a significant position in short-term bonds issued by Lehman, was unable to maintain its $1 share price, thereby "breaking the buck." A "run on the fund" resulted, as investors rushed to redeem their shares. To stop the run, the Fund suspended redemptions. In the end, shareholders received less than $1 per share for their holdings in the Fund.7 In an effort to prevent a reoccurrence of these events, effective May 5, 2010, the SEC adopted revisions to Rule 2a-7. The revisions include:
• Higher Portfolio Quality. The revised rule reduces the amount that a fund may invest in "second tier securities" (securities of issuers rated A or below) from five percent to three percent of the fund’s total assets and limits a fund’s investment in a single issuer of second tier securities to one-half percent.
• Shorter Portfolio Maturity. The revised rules restrict the maturity of a fund’s portfolio and investments requiring that the maximum weighted average portfolio maturity is no greater than 60 days, the dollar-weighted average life to maturity of a fund’s portfolio is no greater than 120 calendar days, and investment in second tier securities must have remaining maturities of less than 45 days.
• Higher Portfolio Liquidity. The revised rules impose daily and weekly minimum liquidity requirements, including a requirement that 10 percent of a taxable fund’s total assets be comprised of "daily liquid assets" and 30 percent of any fund’s total assets be comprised of "weekly liquid assets." Additionally, no more than five percent of a fund’s assets may be invested in illiquid securities.
• Other Changes and Future Reforms. The SEC also adopted rules designed to provide a more orderly liquidation process in cases where a fund does "break the buck," hoping to prevent a "run on the fund" as experienced by Reserve Fund shareholders.8 These rules also assign additional responsibilities to money market fund directors9 and require additional monthly disclosure of portfolio holdings on fund websites.10 The SEC and other regulators continue to explore the possibility of additional significant changes to money market fund regulation, despite significant industry opposition.11
Hedge Fund Investment Adviser Registration
Dodd-Frank required that many investment advisers to hedge funds become registered with the SEC.12 It accomplished this by eliminating the "private adviser" exemption from the registration requirements of the Advisers Act.13 In its place, Dodd-Frank created three new exemptions from registration: (i) advisers to venture capital funds (the VC Fund Exemption), (ii) advisers that advise private funds with aggregate assets under management (AUM) in the United States of less than $150 million (the Private Fund Adviser Exemption), and (iii) advisers located outside of the United States that have limited AUM and clients in the United States (the Foreign Private Adviser Exemption).
The SEC’s rules giving effect to these provisions14 are complex and outside the scope of this article; however, it is important to note that they also revised the framework by which a nonexempt adviser determines whether state or federal registration is required. Under these rules, the amount of an investment adviser’s AUM will generally determine whether the adviser must register with the SEC or the states. An adviser will generally not be permitted to register with the SEC unless it has at least $100 million of AUM. Smaller advisers (called mid-sized advisers) with AUM between $25 million and $100 million are subject to regulation by the states.15
Although exempt from SEC registration, advisers relying on the VC Fund Exemption or the Private Fund Adviser Exemption remain subject to regulation under the Advisers Act as Exempt Reporting Advisers. Exempt Reporting Advisers are required to file, and periodically update, certain information with the SEC, and these reports are publicly available on the SEC’s website.16
Net Worth Standards
Dodd-Frank also mandated that the SEC adjust certain net worth standards contained in the Advisers Act that permit investment advisers to charge a performance fee to "qualified clients," and to adjust the definition of "accredited investor" in the Securities Act, which effectively defines the category of persons that can invest in hedge funds.17
With respect to the Advisers Act, Rule 205-3 generally prohibits an adviser from charging clients a performance fee, unless the client is a "qualified client." Formerly, a "qualified client" included a natural person (i) with at least $750,000 in AUM with the adviser, or (ii) whom the adviser reasonably believed has an aggregate net worth of at least $1.5 million. As revised, these thresholds have been increased to $1 million and $2 million, respectively.
With respect to the Securities Act, hedge funds typically rely on an exemption from registration contained in Regulation D under the Securities Act, which permits a fund to avoid registration if it limits its sale of securities to individuals who are deemed to be "accredited investors." An accredited investor is defined to include a natural person that, alone or together with a spouse, has a net worth of at least $1 million.18 In determining a person’s net worth, the revised rules now exclude the value of an individual’s primary residence as an asset. Formerly, the value of a person’s primary residence had been included, which raised concerns that hedge funds were being distributed to persons who lacked the financial sophistication to properly understand and assume the risks associated with these investments.19
CFTC Commodity Pool Operator Registration
On Feb. 9, 2012, the CFTC adopted amendments to its rules pertaining to commodity pool operators (CPOs).20 These amendments eliminate or modify several exemptions and exclusions commonly relied upon by registered investment companies, their investment advisers, and private investment fund sponsors to avoid registration with the CFTC as a CPO, particularly Rule 4.5 of the Commodity Exchange Act. Rule 4.5 had previously provided an exclusion from the definition of a CPO for advisers to investment companies. The CFTC had become concerned that these exclusions, which were originally adopted in 2003, improperly allowed many funds using managed futures strategies to avoid CFTC oversight.21
The amended rules have caused many advisers, who have never considered themselves to be engaged in the commodities markets, to register with the CFTC. As amended, Rule 4.5 defines a commodity to include securities futures, broad-based stock index futures and financial futures contracts, options and swaps. As a result, funds that invest in these instruments above certain threshold amounts are deemed to be commodity pools, requiring the adviser to that fund to register as a CPO. The threshold amounts established by Rule 4.5 are high. In order to avoid registration, the fund must limit its commodities investments as follows:
• the aggregate initial margin and premiums required to establish any commodity futures, options or swaps may not exceed five percent of the liquidation value of the fund’s portfolio (after taking into account unrealized profits and unrealized losses on any such positions) (percentage-of-margin test); or
• the aggregate notional value of such positions, as determined at the time the most recent position was established does not exceed 100 percent of the liquidation value of the fund’s portfolio (after taking into account unrealized profits and unrealized losses on any such positions) (the "net notional test").
In addition, the fund may not market itself to the public as a commodity pool, or otherwise as a vehicle for trading in the commodity futures, options or swaps markets.
These rules impose difficulties on funds and advisers who are required to register as CPOs and raise the potential for inconsistent and contradictory regulation of funds and CPOs by the CFTC and the SEC. The industry still awaits rules that are intended to harmonize the different regulatory schemes and in the meantime has challenged the CFTC and these rules.22 While a district court has denied that challenge, that decision has been appealed.23
Domenick Pugliese is a partner at Paul Hastings in New York. Max Shakin, an associate at the firm, assisted in the preparation of this article.
1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010) (Dodd-Frank).
2. Some reform efforts will affect advisers and funds indirectly, such as the creation of the Financial Stability Oversight Council (FSOC) and its ability to designate entities, including funds, as "systemically important financial institutions" (see Dodd-Frank, §113), as well as new rules governing swaps and swap counterparties (see Dodd-Frank, §731).
3. We do not address in this article the recently adopted Jumpstart our Business Startups Act (JOBS Act), Pub. L. 112-106, 126 Stat. 306 (2012), which, while not an outgrowth of the financial crisis, will have a significant impact on the hedge fund business by relaxing prohibitions on funds regarding general solicitation and advertising.
4. See Statement of Mary Schapiro, Chairman of the Securities and Exchange Commission (SEC), "Perspectives on Money Market Mutual Fund Reforms" before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, at p.1 (June 21, 2012), available at http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=66f4ddb5-4823-4341-bad9-8f99cdf5fe9a: "The risks posed by money market funds to the financial system are part of the important unfinished business from the financial crisis of 2008." See Statement of Paul Schott Stevens, President and CEO of the Investment Company Institute (ICI), "Perspectives on Money Market Mutual Fund Reforms" before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, at p.2 (June 21, 2012), available at http://www.banking.senate.gov/public/index.cfm?FuseAction=Files.View&FileStore_id=12d86f5f-3e1d-4f64-a2db-f2f7f1126c0a: "Contrary to the suggestions of critics and some policymakers, a careful review of market events demonstrates that money market funds did not accelerate the financial crisis of 2007-2008."
5. 17 C.F.R. §270.2a-7 (Rule 2a-7).
6. See ICI Testimony on Perspectives on Money Market Mutual Fund Reforms, June 21, 2012, at 26. http://www.ici.org/pdf/12_senate_pss_mmf_written.pdf.
7. For the SEC’s account of the events at the Reserve Fund, see SEC Litigation Release No. 21025 (May 5, 2009), available at http://www.sec.gov/litigation/litreleases/2009/lr21025.htm.
8. New Rule 22e-3 permits a money market fund to suspend redemptions and payment of redemption proceeds in order to facilitate an orderly liquidation of the fund so long as the fund’s board of directors makes certain findings and the fund, prior to suspending redemptions, notifies the SEC of its intention to do so.
9. A money market fund’s board of directors must adopt procedures providing for periodic stress testing of the fund’s ability to maintain a stable net asset value per share under various hypothetical conditions. See Rule 2a-7 (c)(10)(v).
10. See Rule 2a-7(c)(12).
11. FSOC has proposed three potential alternative reforms, which are not necessarily mutually exclusive: 1) Floating Net Asset Value, 2) Stable NAV with NAV Buffer and "Minimum Balance at Risk," and 3) Stable NAV with NAV Buffer and Other Measures. See Proposed Recommendations Regarding Money Market Mutual Fund Reform, 77 Fed. Reg. 69455 (Nov. 19, 2012), h ttp://www.treasury.gov/initiatives/fsoc/Documents/Proposed Recommendations Regarding Money Market Mutual Fund Reform – November 13, 2012.pdf.
12. Prior to Dodd-Frank, hedge fund advisers typically relied on the "private adviser" exemption provided in §203(b)(3) of the Advisers Act, which exempted from registration any U.S. adviser with fewer than 15 "clients" and that did not "hold itself out as an investment adviser" to the public. In general, a hedge fund adviser counted as a "client" each fund it advised, rather than the individual investors in those funds.
13. See Dodd-Frank Act, §403.
14. "Rules Implementing Amendments to the Investment Advisers Act of 1940," Investment Advisers Act Release No. 3221(June 22, 2011) (IAA Release No. 3221) and "Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers," Investment Advisers Act Release No. 3222 (June 22, 2011).
15. However, the threshold for eligibility to register with the SEC (rather than the states) remains at $25 million for certain advisers that either (i) are not subject to registration and examination in the state in which they maintain their principal office and place of business or (ii) otherwise would be required to register with 15 or more states.
16. See IAA Release No. 3221 at 56. In contrast, advisers relying on the Foreign Private Adviser Exemption are not subject to ongoing compliance and reporting obligations.
17. See Dodd-Frank, §418 "Qualified Client Standard," and Dodd-Frank, §413 "Adjusting the Accredited Investor Standard."
18. 17 C.F.R. §230.501(a).
19. The rules also contain numerous technical provisions addressing matters such as the calculation of indebtedness secured by the person’s primary residence.
20. See 17 C.F.R. §§4.5 and 4.13(a)(3).
21. See Commodity Pool Operators and Commodity Trading Advisors: Compliance Obligations, 77 Fed. Reg. 11252 (Feb. 24, 2012) at 11255.
22. See Complaint, Investment Company Institute, et al. v. CFTC, No. 1:12-cv-00612 (D.D.C. April 17, 2012). The Complaint is available at: http://www.ici.org/pdf/12_commod_inv_complaint.pdf.
23. Investment Company Institute v. CFTC, No. 12-cv-00612 (D.D.C. Dec. 12, 2012). The district court opinion is available at https://ecf.dcd.uscourts.gov/cgi-bin/show_public_doc?2012cv0612-42.