Will Hedge Fund Registration Overwhelm the SEC?

Date: Wednesday, April 13, 2011
Author: Lori Ann LaRocco, CNBC

Looks like another deadline of the Dodd-Frank Bill will come and go. This one is the much talked about July 21 hedge fund registration deadline.

SEC Associate Director Robert Plaze recently sent a letter to the President of the North American Securities Administrators Association Inc., saying "we expect the Commission will consider extending the date ... until the first quarter of 2012."

The letter said advisers with assets between $25 million and $100 million are likely to get a six-month grace period. So is the SEC playing nice with the hedge fund sector? Or are they simply unable to handle the workload? I decided to ask Tom Westle, Partner at Blank Rome LLP, who represents hedge funds, about this latest development.

LL: Will the SEC be able to handle all the expected reviews/audits?

TRW: Honestly, as of today, I believe the answer is no. I am not certain that they would agree with my response but, in my opinion, the staff of the SEC that is charged with the examination process has a learning curve to deal with before they are fully prepared to examine the hedge fund industry. Even taking into consideration the reduction of the number of advisers that will have to register with the SEC because of the $150 million threshold, I think that

then sheer number of newly registered advisers will cause issues for timely examinations by the SEC staff. In time, just as with the mutual fund industry, a system will evolve whereby a percentage of advisers are examined annually and sweep examinations will be conducted to review specific concerns.

However, even with a robust examination staff, the magnitude of this task will increase and not decrease as the SEC uncovers additional issues that might require examination. The hedge fund industry will have to work with the SEC to develop appropriate levels of examination and to educate the staff with respect to the nuances of this industry similar to the way that the mutual fund industry has done.

LL: Do you think the grace period being proposed for the mid-size funds is more do the work load at the SEC or to give these firms more time?

TRW: Initial reactions may be that the grace period was granted based on push-back from the industry. The reality may be that the work flow at the SEC is not equipped to handle the job at the present time.

LL: Over a third of the $1 billion plus hedge funds have not yet registered with the SEC. They have until July 21. Are they playing a waiting game to see what their competition is disclosing to regulators?

TRW: This may be a waiting game by some to provide time to review disclosures made by similar hedge fund advisers in their position or by their competitors. It is not unusual for disclosure documents to closely resemble each other.

There is also some degree of procrastination. Why register before the absolute deadline when the regulation may be postponed? Lastly, there are always the few who, when they were younger, did their homework the morning it was due—and they may now be running some of these hedge funds.

LL: Non-US hedge fund managers who have US investors are waiting on the SEC's decision in May to see if they need to register or just report to the regulators. Do you think they need to register?

TRW: Comments on the SEC proposal regarding registration by foreign private advisers were due in January and now the industry is waiting the final Rule to be adopted to see what it will end up saying and requiring. I would assume that something close to the proposed rule will be adopted by the SEC requiring some of the foreign advisers to register and others be required to provide information only as is the case with certain U.S. hedge fund advisers.

Until the final rule is adopted, I would not recommend that they register. If the circumstances are right, I would counsel a client to seek exemption from registration before submitting to the rule.

LL: One of the biggest questions for policymakers has been whether the systemic risk of hedge funds is remediable by lawmaking and socially undesirable. Do you think policymakers will be able to achieve success in this area?

TRW: To a degree, we should be able to reduce some of the systemic risk of hedge funds by lawmaking and making them socially undesirable.

However, notwithstanding full disclosure, the introduction of compliance at the top, compliance officers and compliance manuals in hedge fund shops, future SEC examinations and successful SEC enforcement actions and states’ attorney general prosecutions, I think that as with any industry there will continue to be some degree of systemic risk in the hedge fund industry.

This is an industry that is often on the cutting edge, developing new derivative securities and investment schemes each with their own level of new risk, some of which is not even known for years after the security is in the marketplace. The pressure and the inherent competition to perform and to provide amazing returns to investors is such that I think there will always remain a degree of systemic risk that no regulation can fully extinguish.

LL: Do you think as Hedge Funds become more mainstream it will be easier for the industry to demystify itself?

TRW: I think that over the last several years with increased retailization of hedge funds, we have seen a demystification of the hedge fund industry. Documentation and disclosure has improved. It is not quite at the level of “plain English” as is required for registered investment companies.

However, more private placement memorandum are drafted with an attempt to provide disclosure in a more readable manner. Many hedge fund strategies have found their way into more retail products such as mutual funds which has also lead to some of the demystification.

LL: What are you advising your clients during this time of uncertainty?

TRW: We advise clients that they should adopt industry best practices as much as possible, establish a tone of compliance from the top, make the compliance officer a part of the investment process and, if there is any uncertainty with respect to the requirement to register, err on the side of conservatism and complete the Form ADV and start the registration process. If it is clear that they do not qualify for federal registration, the water becomes much murkier.

Most of the states are still developing their regulations and there may be more uncertainty regarding the need to register in a state or even more than one state. I guess the Boy Scout motto fits best here; “Always be prepared.” The consequences of not having registered and being found to be out of compliance are too great.