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By John Brunjes and Genna Garver, Bracewell & Giuliani — President Obama’s plan to modernize financial regulation and supervision reflects a complex and consequential policy that directly impacts private investment funds and their managers. Most significantly, all managers of hedge funds and other private pools of capital, including private equity and venture capital funds, whose assets under management exceed some “modest threshold,” would be required to register with the SEC. Managers also would be required to report information to the SEC on the funds they manage to assess whether they should be further regulated by the Federal Reserve. Obama’s plan would also broaden SEC authority over all SEC-registered-registered investment advisers.

SEC Registration of Fund Managers

The lack of specificity behind the “modest threshold” of assets under management that would trigger SEC registration leads the list of head-scratchers in the Obama plan. Obama has yet to suggest a particular number. Under current law, the SEC regulates managers with client assets over $25 million, while regulation of managers with client assets under $25 million is reserved for the states. Depending on the amount of the “modest threshold,” managers currently regulated by the SEC may instead become subject to state regulation. Considering recent SEC enforcement fumbles, Obama may have good reason to raise the $25 million threshold to avoid spreading the SEC too thin—a move that would appeal to state securities regulators. The “modest threshold” may take on greater relevance if the so-called “private client exemption” from registration under the Investment Advisers Act is eliminated as discussed below.

Another head-scratcher in the Obama plan is how he intends to rein in those managers who currently slip through the regulatory cracks (once beyond the grasp of state regulators) by the “private client exemption” from registration for advisers with 15 or fewer clients—where the term “clients” is defined in a way that allows each fund to be counted as a single client even where the underlying limited partners may number into the hundreds. Legislators in the current session of Congress have already proposed bills that would eliminate the private client exemption, including H.R. 711, “Hedge Fund Advisers Registration Act of 2009,” proposed by Representatives Michael Castle (R-DE) and Michael Capuano (D-MA), and S.1278, “Private Fund Transparency Act of 2009,” proposed by Senator Jack Reed (D-R.I.).

If the private client exemption is eliminated, all fund managers with client assets exceeding Obama’s “modest threshold” would be required to register with the SEC (absent the availability of another exemption). Fund managers with client assets under Obama’s “modest threshold” would likely fall under the supervisory authority of their home state, but not necessarily safe from registration—state legislatures, like Connecticut, are also considering closing the regulatory cracks for investment advisers and may follow suit. Ultimately, registration of fund managers with either the SEC or their home state securities regulator seems imminent.

As SEC-registered investment advisers, fund managers would be subject to the Investment Advisers Act of 1940 and its bevy of regulations, including significant recordkeeping requirements, compliance procedures, reporting requirements, advertising restrictions, and prohibitions on certain transactions. In addition, the Obama plan proposes to subject all funds advised by SEC-registered advisers to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; regulatory reporting requirements, and SEC examinations to monitor compliance with these requirements. The regulatory reporting requirements for such funds would require reporting on a confidential basis of the amount of assets under management, borrowings, off-balance sheet exposures, and other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that requires greater regulation for financial stability purposes.

Possible Supervision and Regulation of Funds by Federal Reserve as a Tier 1 FHC

The Obama plan would authorize the SEC to share with the Federal Reserve the confidential reports of funds advised by SEC-registered investment advisers. The Federal Reserve would determine whether any of those funds or fund families requires greater regulation for financial stability purposes (the Obama plan refers to those funds as “Tier 1 Financial Holdings Companies” or “Tier 1 FHCs”). The Federal Reserve would also have authority to examine any of those funds if the Federal Reserve is unable to determine whether the fund’s financial activities pose a threat to financial stability based on regulatory reports, discussions with management, and publicly available information. Toward that end, the Obama administration will propose legislation setting forth criteria that the Federal Reserve should consider in identifying Tier 1 FHCs, which as presently envisioned would include the following factors:

* the impact the firm’s failure would have on the financial system and economy;
* the firm’s combination of size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding; and
* the firm’s criticality as a source of credit for households, businesses, and state and local governments and as a source of liquidity for the financial system.

In addition, the Federal Reserve would be allowed to consider other relevant factors and exercise discretion in applying the specified factors to individual financial firms.

Once identified as a Tier 1 FHC, a fund would be subject to heightened supervision and regulation by the Federal Reserve. At a minimum, Tier 1 FHCs would be required to meet the qualification requirements for “financial holding companies” set forth in the Bank Holding Company Act of 1956 and its regulations, including being well capitalized and well managed. However, the prudential standards for Tier 1 FHCs — including capital, liquidity and risk management standards — would be stricter and more conservative than those applicable to other financial firms to account for the greater risks that their potential failure would impose on the financial system. How much stricter and more conservative has yet to be revealed.

As if the obvious terminology weren’t a sufficient hint, funds identified as Tier 1 FHCs would be subject to regulation and supervision currently reserved for depository institutions and their holding companies. Obama’s message is clear: the presence of large, unregistered funds in the U.S. “shadow banking system” must come to a swift end.

The question lingering is how the framework established for banks and bank holding companies, including the prudential capital, liquidity and management standards, would be applied to private investment funds. Such concepts as maintaining risk-based capital and leverage ratios and restricting nonfinancial activities cannot be directly applied to a fund, at least not without further regulatory clarification. In fact, the concept of maintaining capital is in part contrary to the investment business of most funds. Unlike bank depositors, fund investors commit capital with the objective of capital appreciation, not preservation for liquidity. In addition, the legal form of most funds is a limited partnership, not a stock-based bank charter, rendering the current capital adequacy guidelines almost nonsensical in their application to funds. Although Gramm-Leach-Bliely permits financial holding companies to conduct all financial and many nonfinancial activities, the Glass-Steagall wall between the banking and commerce remains, at least in part.

The restrictions on nonfinancial activities (except insofar as found incidental or complementary to financial activities) would prohibit many controlling investments traditionally made by private equity and venture capital funds.

Greater SEC Regulation of All Investment Advisers

Even SEC-registered investment advisers who provide advice solely on a managed account basis face greater regulation. The Obama administration will propose legislation to empower the SEC to bolster protections for all clients of SEC-registered investment advisers by:

* Requiring simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment advisers;
* Prohibiting certain conflicts of interest and sales practices that are contrary to the interests of investors — the SEC would be empowered to examine and ban forms of compensation that encourage investment advisers to put investors into products that are profitable to the adviser, but are not in the investors’ best interest; and
* Prohibiting mandatory arbitration clauses in investor contracts (after the SEC conducts a study on whether investors are harmed by being unable to obtain effective redress of legitimate grievances, as well as whether changes to arbitration are appropriate).

Although the Obama plan leaves many questions unanswered, greater regulation and supervision is imminent and fund managers should not assume the luxury of significantly delayed effective dates. However, fund managers should be cautioned not to run to register in advance without understanding its implications, or to adopt policies and procedures not specifically tailored to your business or risks. Instead, while Congress reviews the Obama plan, fund managers should review their business—identify conflicts of interest, business practices, arrangements, and other factors creating risk for the fund manager and its clients in relation to its operations. Then fund managers should review or develop, as the case may be, policies and procedures that specifically address those factors and the controls to be implemented to supervise and mitigate those areas of concern.

John Brunjes and Genna Garver are in the Private Investment Funds Group of Bracewell & Giuliani, LLP, representing hedge funds, private equity funds and venture capitalists in connection with fund formation and operations issues and illiquid investment transactions, with particular emphasis on advising private domestic and offshore capital pools and their stakeholders. John is head of the Fund Formation practice and a member of the Board of Directors of the Connecticut Hedge Fund Association.

The NYT ran an article this Sunday about visiting Malibu called 36 Hours in Malibu. They were obviously referencing how long it takes to get there from Santa Monica – the next town below.

If you’re visiting from afar, plan on staying 2 days max. You can see it all quickly – or very slowly, depending on how bad the traffic is on the Pacific Coast Highway (PCH). There’s Nobu, Malibu Wine, and uh, Nobu – and that’s about it. It’s better if you know someone and have a place to stay overlooking the ocean. Killer views and sunsets.

Ask Emilio, he’s got the vineyard and the views…

Morningstar had an interesting article on managing risk. Problem with the author’s methodology is that it is way too subjective. People are emotional about money. You need to have a pre-determined “puke” point where you get out no matter what. You cannot make decisions about money on the spot. Remember: Price moves first, then the fundamentals follow. Unless you’re a CFA and do this for a living, take your small losses regularly and move on.

The former head of ailing U.S. insurance giant AIG told a court on Wednesday that he had a private jet fly a large block of the company’s stock to Bermuda from New York to prevent AIG from seizing it. “It was a reaction to the entire environment that was emerging between AIG and Starr International,” Maurice “Hank” Greenberg told U.S. District Judge Jed Rakoff. “It was starting to get very ugly.”

Huge rally yesterday in Westwood at Wilshire and Veteran. The Persian community was out in full force to protest what’s happening in Tehran. Reports today suggested that the vote count is off by as many as 3 million votes.

The Annual Father’s Day Rodeo Drive man-hood show in Beverly Hills brought out some rare, exotic, and hard-to-price models. How would you value some of these for Estate Planning purposes?

I took some good shots, but these are far superior to mine.

Ever get a call when you’re right in the middle of something, tell the person “I’ll call you right back!” and then remember 7 hours later that you owe someone a call? This is a cool BlackBerry app that will help you remember by putting a reminder right on your calendar. Free download too.

Madoff turned the table on the client: he had it set up so that he basically interviewed them for admittance. That made the potential client want it more. I can’t imagine how those people feel right now.

When your money manager is the:

broker/dealer
custodian
investment advisor

you have to have a lot of trust for that person or entity. To me, that type of trust would rank with God or a higher power.

I hold the SEC responsible because they were alerted and they were too afraid to ask for what they needed. Politics has no place in fiduciary care.

So far, nothing has changed since Madoff. There are proposals, but nothing has changed.

I’ve heard about having Senior Citizen retaking a driving test to make sure their ability is sharp and that they don’t plow into people at the Farmer’s Market.

The death of the 60-year-old captain of a Continental Airlines jetliner as he flew 247 passengers across the Atlantic could spark a new debate over age limits in the cockpit.

Craig Lenell, the pilot who died Thursday, was believed to have suffered a heart attack. A cardiologist aboard the plane tried to revive him with a defibrillator.

Until 2007, U.S. rules required airline pilots to retire at 60, but Congress raised the limit to 65.

Should there be age limits on driving or Piloting? What say ye?

First it was “Death Due to Smoking” then the growth of the National Debt in real-time. Now there is a Times Square billboard that calculates the Carbon released into the atmosphere.