The US Securities and Exchange Commission has come under fire on two fronts as it attempts to reform the regulatory oversight of the US mutual and hedge funds industries.
On September 2 the US Chamber of Commerce filed a lawsuit to try to derail an SEC rule that would require mutual funds to have independent chairmen – a case the regulator will vigorously contest. Just days later, the SEC received a letter from a Washington DC law firm questioning its rulemaking authority over proposed hedge fund reforms.
Wilmer Cutler Pickering Hale and Dorr argued that the SEC would be going beyond its authority if it forced hedge fund advisers to register with the regulator. Wilmer Cutler cited Ernst & Ernst v Hochfelder (1976) as saying: “The rulemaking power granted to an administrative agency charged with the administration of a federal statute is not the power to make law. Rather, it is the power to adopt regulations to carry into effect the will of Congress as expressed by the statute.”
The proposed SEC rule would force advisers to private funds to register under the Investment Advisers Act of 1940 if they had more than 14 clients. The legislation, which underpins the regulation of US funds, exempts those with 14 or fewer clients. To determine if they are exempt, advisers to private funds would have to look through the funds they advise on and calculate the number of investors in each, rather than treating each fund as a single client as they do at present.
“The [SEC] does not have the authority to eliminate the statutory exception for investment advisers with fewer than 15 clients from the registration requirements of the Advisers Act,” said the firm. “Counting clients by the look through method the Commission now proposes is contrary to the text and the entire history of the Advisers Act.”
In changing the way funds count clients and including private funds with two-year redemptions, the rule would sweep up most hedge funds. The SEC argues that this would enable it to give the public better information about the market, spot compliance problems and demand that all hedge fund advisers take on basic compliance controls. It estimates 40% to 50% of hedge fund advisers are already registered, but scandals in the mutual funds industry and concerns over the involvement of retail investors in hedge funds have put pressure on the regulator to tighten its oversight.
The SEC voted in July to put the rule forward for public comment. That period ended in September and the SEC will examine the responses before putting a final rule to what is expected to be a split vote. The SEC received approximately 150 comments on the proposal, including letters from about 20 law firms.
Lawyers tend to couch public comments to the SEC in cautious, usually technical terms, and Wilmer Cutler has struck an unusual note in making a direct criticism of the regulator's proposals. It declined to comment further on the submission, saying that the letter provided a full explanation of the firm's position.
But Wilmer Cutler is not alone in arguing against the proposal. Willkie Farr & Gallagher, in its comment letter, said: “The Commission's proposal is inconsistent with... congressional intent and indeed does violence to the statutory pattern. If adopted, in our view it would be reversible as a matter of law.”
The Mutual Funds Association (MFA), also questioned the SEC's authority and the US Chamber of Commerce said: “The proposed rule is at best an unwarranted reversal of long-standing regulatory interpretations of the federal securities laws and at worst an action that exceeds the Commission's authority and could result in a round of protracted but unnecessary litigation.”
Other lawyers disagree that hedge fund registration goes beyond the SEC's remit. They argue that the SEC has taken a reasonable reading of the law. “The tide has come this way and I don't think that [the argument] will wash,” says Yvonne Chan of Paul Weiss Rifkind Wharton & Garrison in New York.
Accepting that the SEC has the right to pass the rule does not mean lawyers necessarily agree with the proposal, however. Their comments included a number of criticisms, and several assert the main opposition arguments – that registration would be a burden to hedge funds, raising costs and potentially having a chilling effect on the industry, while failing to achieve more effective oversight.
Other respondents supported the proposal. Among these was industry group the Investment Company Institute, which said: “Far from being draconian, the Commission's proposal is a measured and appropriate response to address the risks that hedge funds pose.” Others pointed out that other developed financial markets, including the UK, already require hedge fund registration.
The SEC must now assess the comments and put the proposals to a final vote, with commissioners Cynthia Glassman and Paul Atkins opposed. Chairman Donaldson, who currently holds the swing vote, is likely to press the proposal through. With the US presidential election looming, and with it potential changes in the SEC's membership, that is likely to be sooner rather than later.
What will happen when the rules come into force is unclear. The arguments put forward by the MFA and Chamber of Commerce suggest they might consider legal action. To bring that against an SEC rule would be unusual, and to succeed in it even more so. But with passions inflamed, somebody in the $800 billion hedge fund industry might decide to do so. Either way, lawyers stand to win some new work.