The following is an edited version of a speech delivered by Norm Champ, director of the Securities and Exchange Commission's Division of Investment Management, at the Practising Law Institute's Hedge Fund Management Conference in New York on Sept. 12.
This is truly an opportune time to examine the regulatory landscape for hedge funds and their advisers. Many of you are probably returning from vacations during a summer that witnessed the third anniversary of the enactment of the Dodd-Frank Act and just in time for the effective date of some significant rule makings relating to a private-placement exemption often used by hedge funds. As you know, the Dodd-Frank Act imposed greater oversight on advisers to hedge funds, while recent changes were made to the private-placement exemptions by the [Jumpstart Our Business Startups] Act. These changes create both opportunities and challenges for those advisers managing hedge funds.
I will begin with a discussion on what you are likely most interested in: the general solicitation and “bad actor” rules. Afterward, I will focus on our continuing efforts to be better-informed regulators. In the post-Dodd-Frank era, we are more cognizant regulators not only because of the enhanced data we receive from you regarding the size and operations of your industry but also due to our continuous efforts to improve our ability to use that data and our heightened focus on industry awareness. After an overview of what we now know about your industry and how we intend to use it, I'll highlight some regulatory initiatives of interest to the hedge fund industry. However, before I finish, I want to share some thoughts on the importance of a robust culture of compliance, which is underscored by the recent commission actions against hedge fund managers for insider trading.
Over the summer, the commission adopted two significant congressionally mandated changes to Rule 506 of Regulation D — the private-placement exemption that many hedge funds rely on to offer their interests in the U.S. Before addressing some specific aspects of these rules, it may be helpful to quickly revisit how we got here.
As most of you know, the JOBS Act mandated that the commission lift the ban on general solicitation and general advertising to, among other things, provide new ways for companies to raise capital. We are committed to taking steps to pursue additional investor safeguards, if and where such measures become necessary once the ban on general solicitation is lifted. In other words, as we fulfill our mission to facilitate capital formation, we remain focused on strong investor protections. Therefore, in connection with the changes to Rule 506, the commission proposed additional amendments intended to enhance the commission's ability to evaluate the development of market practices in Rule 506 offerings and address certain concerns raised by commenters related to the types of investors that would be attracted by general solicitation.
The first change to Rule 506 eliminates the prohibition on general solicitation and general advertising for certain offerings, including hedge fund offerings, provided that the conditions of the new rule are met. Once the removal of the ban becomes effective in the next few weeks, hedge fund issuers will be able to use a number of previously unavailable solicitation and advertising methods when seeking potential investors. However, with these new marketing opportunities also comes greater responsibility.
The final rule permits issuers to use general solicitation and general advertising to offer their securities if, among other things, issuers take reasonable steps to verify that all purchasers of the securities are accredited investors — meaning that at the time of the sale of the securities, they fall within one of the categories of persons who are accredited investors or the issuer reasonably believes that they do. Determination of the reasonableness of the steps taken to verify that an investor is accredited is by an objective assessment by an issuer, and in response to comments, the final rule provides a nonexclusive list of methods that issuers may use to satisfy the verification requirement for individual investors.
With general solicitation and general advertising soon to be an option, I want to reiterate the commission's reminder from the adopting release that advisers to private funds are subject to an anti-fraud rule that prohibits fraudulent and misleading conduct with respect to fund investors, including making untrue statements of material fact to those investors. In the adopting release, the commission also noted that investment advisers who have implemented appropriate policies and procedures regarding the nature and content of private-fund-sales literature are less likely to use materially misleading advertising materials or otherwise violate federal securities law. Accordingly, advisers should carefully review their policies and procedures to determine whether they are reasonably designed to prevent the use of fraudulent or misleading advertisements and update those policies where necessary, particularly if the hedge funds intend to engage in general-solicitation activity. Hedge fund sponsors intending to rely on the new rule also should consider whether their current practices for verifying accredited-investor status meet the requirements of the new rule.
Simultaneously with the adoption of these amendments, the commission issued a proposal designed to enable the commission to evaluate how general solicitation impacts investors in the private-placement market. The proposed measures include, among other things, expanding the information that issuers must include on Form D, requiring issuers to file the Form D before a general solicitation begins and when an offering is completed, and putting in place a more effective mechanism for enforcing compliance with Form D filing requirements.
Given that private funds raise a significant amount of capital in Rule 506 offerings, the proposal contains several amendments specific to private funds. For example, private-fund issuers would be required to include a legend in any written general-solicitation materials disclosing that the securities being offered are not subject to the protections of the Investment Company Act of 1940. With respect to written general-solicitation materials containing performance data, additional disclosure would be required to explain the limitations on the usefulness of such data and provide context to understand the data presented.
The commission also proposed to extend guidance contained in Rule 156 under the Securities Act of 1933, currently applicable to registered funds, on when information in sales literature could be fraudulent or misleading for purposes of the federal securities laws. This guidance would apply to all private funds, whether or not they are engaged in general- solicitation activities. In the proposing release, the commission expressed its view that private funds should begin considering the principles underlying existing guidance now.
Furthermore, the commission requested comment on additional manner and content restrictions on private-fund solicitation materials. In particular, we are interested in hearing your thoughts on content restrictions on performance advertising generally and content standards specific to certain types of performance advertising, such as model or hypothetical performance. We also are interested in your views on whether private funds should be subject to standardized performance reporting and, if so, what reporting standards should apply.
In order to assist the commission's efforts to assess developments in the Rule 506(c) market, an inter-divisional group has been created within the commission to review the new market and the practices that develop. Staff from the Division of Investment Management will play a key role in this initiative and will work closely with staff from the Division of Corporation Finance; the Division of Economic and Risk Analysis, formerly the Division of Risk, Strategy and Financial Innovation; the Division of Trading and Markets; the Office of Compliance Inspections and Examinations; and the Division of Enforcement. As part of the work plan, staff will, among other things, evaluate the range of accredited-investor verification practices used by issuers and other participants in these offerings, and endeavor to identify trends in this market, including in regard to potentially fraudulent behavior. Commission staff also will develop risk characteristics regarding the types of issuers and market participants that conduct or participate in offerings involving general solicitation and general advertising, and the types of investors targeted in these offerings.
In addition, I've instructed Division of Investment Management rule making, and risk and examination staff, to pay particular attention to the use of performance claims in the marketing of private-fund interests. In particular, this review will endeavor to identify potentially fraudulent behavior and to assess compliance with federal securities laws, including appropriate Investment Advisers Act provisions. I encourage you to provide us information about what you are seeing develop in regard to general solicitation by private funds, particularly advertisements that appear to raise concerns.
Separately, the commission has begun a review of the definition of “accredited investor” as it relates to natural persons. The commission also requested comment on the definition of “accredited investor” in its recent proposing release. Your input into all these regulatory initiatives is important. With the comment period for the proposals regarding the Rule 506(c) market about to close, we strongly encourage you to submit comments if you have not done so already.
"BAD ACTOR' AMENDMENT
Under the second adopted amendment, commonly referred to as the “bad actor” amendment, an issuer cannot rely on the Rule 506 exemption from registration if the issuer or any other person covered by the rule is disqualified by a “triggering event,” which includes certain criminal convictions, certain SEC cease-and-desist orders, and court injunctions and restraining orders. In addition to issuers such as hedge funds, other potential “bad actors” under the rule could include a hedge fund's general partner or managing member, its investment adviser and principals, significant shareholders holding voting interests, affiliated issuers and any placement agent or other compensated solicitor.
The final rule provides an exception from disqualification for issuers who can show they did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. Given the serious consequences of a bad-actor finding, hedge fund advisers should take care when hiring em-ployees and screening invest-ors, and conduct appropriate due diligence when retaining third-party solicitors. Also, it is important to note that while disqualification applies only to triggering events that occur after the effective date of the rule, matters that existed before the effective date of the rule that would otherwise be disqualifying must be disclosed to investors.
I understand that the staff has received some interpretative questions with respect to the application of these rules, especially to private funds and their advisers. Right now, the staff is in listening and information collection mode, and is evaluating the need for guidance.
MORE COMPLETE PICTURE
As I alluded to earlier, as a result of registration and reporting reforms introduced by, or tangential to, Dodd-Frank, we now have a more complete picture of the hedge fund universe, including insight into (for starters) the number of advisers and funds, the different types of funds, the strategies that they employ and the makeup of their investor base.
Today, the commission's registrant population consists of over 10,825 advisers, with 2,572 of these advising at least one hedge fund. Overall, advisers of hedge funds account for over $4.6 trillion in cumulative regulatory assets. In addition to hedge fund advisers registered with the commission, we also have exempt reporting advisers, or ERAs, who are those advisers exempt from registering with the commission but subject to limited reporting about their businesses and their private-fund clients. The commission has approximately 2,400 ERAs, with 767 advisers, or 32% of these, managing hedge funds accounting for over $819 billion in regulatory assets.
This improved information is the result of upgrades to Form ADV and the arrival of Form PF. In 2011, the commission adopted amendments to Form ADV requiring significant additional information with respect to, among other things, the identity of hedge fund clients, amount of gross assets, names of service providers to these hedge funds, and the number and types of hedge fund investors. Also in 2011, the commission adopted Form PF jointly with the Commodity Futures Trading Commission. Form PF requires advisers to report the use of leverage, counterparty credit risk exposure and trading practices for each hedge and other private fund managed by the adviser. In the summer of 2012, the commission began to receive the first set of Form PF filings from the largest advisers of hedge funds and other private funds, and received a complete set of initial filings from all reporting advisers earlier this year.
While the primary aim of Form PF was to create a source of data for the Financial Stability Oversight Council to use in assessing systemic risk, the commission, consistent with statutory authority, is using the information to support its own regulatory programs, including examinations, investigations and investor protection efforts relating to private-fund advisers. Through a coordinated effort of staff members across the commission, we have identified a number of uses of the information.
For example, last year, the Division of Investment Management created its Risk and Examinations Office. REO is a multidisciplinary office staffed with analysts with strong quantitative backgrounds, along with examiners, lawyers and accountants. REO intends to conduct rigorous quantitative and qualitative financial analyses of the investment management industry, strategically important invest- ment advisers and funds. REO, in collaboration with the Division of Economic and Risk Analysis, is using Form PF data to develop risk-monitoring analytics, as well as to provide internal periodic reports regarding the private-fund industry and particular market segments.
Division staff members also will use Form PF data to inform policy and rule making with regard to private funds, and we intend to use aggregated nonproprietary data in our consultative work with other securities regulators on issues of mutual interest. Similarly, other divisions are beginning to utilize this data to advance their missions.
That said, I know that the hedge fund industry has raised concerns about the confidentiality of Form PF data. However, I can reassure you that the commission takes the protection of the confidentiality of this information very seriously. To comply with enhanced confidentiality provisions established under the Dodd-Frank Act with respect to Form PF, the commission staff has developed a secure filing environment for Form PF to protect the information when and after it is filed. In addition, we have established an interdivisional steering committee to address internal data use and create a comprehensive policy on access to and use of Form PF data.
Of critical importance to expanding the utility of the data is our confidence in the information provided by filers. The division staff is proactively trying to improve data quality by, for example, issuing FAQs on interpretive issues that commonly arise from filers. In fact, we most recently updated our FAQs last month.
As a complement to the data that we receive, we are working to improve our awareness of the industry through a hands-on outreach initiative. While data is important for providing census information, identifying aberrational performance and systemic trends, it does not give you a sense of a firm's culture and approach to compliance.
In order to get a firsthand view of advisers' systems, controls and culture, REO staff members, OCIE leadership and I have met with senior management of many larger, strategically important advisers, many of whom have an institutional line of business through which they manage private funds.
Also, our colleagues in OCIE have begun their presence exam initiative, which is part of an outreach to engage directly with newly registered advisers to private funds. This initiative is focused on five key areas of risk: marketing, portfolio management, conflicts of interest, safety of client assets and valuation. OCIE is still in the engagement phase of this initiative and expects to report back to the industry at the conclusion of the program.
After several years of diligent work, I am happy to report that the Dodd-Frank-mandated rule making directly related to investment advisers is complete. While there are outstanding proposals on the Volcker rule and incentive compensation, each of which may impact investment advisers that charge performance fees and/or accept investments from, or are owned, by banks or bank-sponsored funds, the division will attempt to turn some of its attention to other regulatory initiatives regarding advisers to hedge and other private funds.
One of our longer-term initiatives is a review of the rules that apply to private-fund advisers. Although the principles-based Advisers Act regime has largely stood the test of time despite being applied to an increasingly diverse set of adviser business models, the staff is evaluating whether Advisers Act rules require modernization to reflect the current business and operations of private-fund advisers. This initiative has been spurred, at least in part, by the inquiries and feedback that we receive from industry stakeholders, especially from new registrants.
As one might expect, a review of the Advisers Act regime is no small task, and the process, along with any potential rule making, will take time to run its course to ensure that we get it right. That being said, the division will actively consider providing guidance where appropriate. For example, with respect to the Advisers Act custody rule, we are open to public input on issues and concerns regarding implementation of the rule. Just last month, the division's staff issued guidance regarding the application of the custody rule to private stock certificates, which rightly focused on investor protections provided by fund audits. Although we understand that this guidance may not end our work in regard to the custody rule, it does represent a significant step forward and is an example of our efforts to clarify the application of the rules, while at the same time promoting robust investor protection.
Earlier, I touched upon our outreach initiative designed to get a sense of an adviser's culture of compliance. While our experience, thus far, generally confirms that most investment advisers attempt to do the right thing in fulfilling their regulatory compliance obligations, the recent highly publicized string of insider trading cases in the hedge fund industry highlights the need for improvement.
To borrow a recent quote from Harvey Pitt, a former chairman of the commission, “When it comes to compliance, you have to live, eat, breathe and drink it.” This observation is particularly fitting with respect to the prevention of insider trading. As you know, the Advisers Act requires advisers to establish, maintain and enforce written policies and procedures reasonably designed to prevent misuse of insider information. In addition, Advisers Act provisions require, among other things, the adoption of a written code of ethics that sets forth standards of business conduct and that requires compliance with federal securities laws. However, the prosecution of alleged insider trading continues to be an area of active enforcement by the commission.
In light of these cases, advisers should revisit their compliance policies and procedures, and assess whether they effectively provide a comprehensive framework for the identification and prevention of the misuse of nonpublic information. In addition, advisers should provide continuous training and guidance to ensure that employees know what to do — or, more importantly, what to refrain from doing — when they come into possession of inside information.