Following the corporate scandals that engulfed the US after the fall of Enron, investment funds and investment advisers have been suffering their own series of US scandals. These troubles have led to lawsuits, new investment industry regulations, additional proposed rules and a general increase in the US scrutiny of funds and advisers. To date, most rule-making efforts have been targeted at investment funds and advisers that are registered with the US Securities and Exchange Commission (the SEC). This approach means that most non-US investment funds and advisers have so far not been directly affected, because they tend not to be registered with the SEC. Nevertheless, the changes underway in US fund and adviser regulation may affect the non-US investment industry in a number of ways, in particular if specific US reforms inspire similar reforms or intentionally different regulatory approaches in other countries.
Changes for registered investment funds
As part of its general effort to improve transparency and investor confidence in corporate America, the SEC has adopted new rules as to how investment funds should vote the proxies they hold in regard to the portfolio companies in which they invest. The new rules require SEC-registered investment funds to disclose the policies and procedures they use to determine how to vote proxies and to file with the SEC and make available to shareholders records of how they have voted those proxies. While the SEC does not require that any specific policies or procedures be followed, it has suggested that funds devise policies and procedures governing the extent to which they will delegate proxy voting decisions to their investment advisers or other third parties or rely on the recommendations of third parties. The rules also suggest that it ‘would be appropriate’ (although not mandatory) for funds to disclose the specific policies and procedures they will follow with respect to corporate governance matters, proposed changes to a company’s capital structure, management compensation matters and social and corporate responsibility issues. As part of its specific effort to address abuses in the investment industry, the SEC has already adopted one new rule and is expected to adopt many others. The new rule requires SEC registered funds to:
- Implement written compliance policies and procedures that are annually reviewed for efficiency and adequacy
- Designate a chief compliance officer responsible for those policies and procedures who reports to the board of directors
Compliance with this rule is required by 5 October 2004.
In addition to the above, the SEC has proposed several additional sets of new rules and rule changes that are currently subject to public comment and that are expected to be adopted in final form in the coming months, although no specific date for issuance of the final rules has been given.
A number of mutual funds have been accused of allowing selected customers to engage in late trading. Late trading is the purchase or redemption of fund interests after 4pm New York time (when most funds calculate the price at which they will execute all orders already received that day) at the 4pm price. Late traders can give themselves an unfair advantage by trading based on events that occur after 4pm at a price that does not reflect those events. While most forms of late trading were banned by the SEC in 1968, late trading through intermediaries has remained a legal loophole. Under current SEC rules and staff interpretations, funds may treat the time of receipt of an investor’s order by an intermediary as the relevant time for determining which price the order will receive. It has been common industry practice for intermediaries to transmit their clients’ purchase and redemption orders that were accepted before 4pm to a fund for processing after 4pm at the 4pm price. With the intent of thoroughly eliminating late trading, the SEC has proposed that all SEC-registered fund orders be received by a fund (or its primary transfer agent or its registered securities clearing agency) by 4pm New York time. Although such a rule could significantly affect certain intermediaries, the SEC has proposed a long transition period, which may last a year, to ease its implementation.
The SEC has also proposed enhanced disclosure requirements, requiring SEC-registered funds to disclose:
- Market timing policies and procedures, whereby funds may prohibit or seek to discourage investors from trading in and out quickly
- Practices regarding ‘fair valuation’ of their portfolios
- Policies and procedures with respect to the disclosure of their portfolio holdings. Another disclosure proposal requires detailed breakpoint disclosure, which is intended to reduce the likelihood of investors being overcharged. Breakpoints are the levels, or ‘points’, of investment at which an investor becomes eligible for reduced sales fees, effectively earning a discount for making a larger investment
Furthermore, the SEC has proposed rule changes to enhance the independence of funds’ boards with the intention of making such influence less potentially self-interested. Significantly, the SEC wants independent directors to comprise at least 75% of a fund’s board. It is envisaged that such an independent majority would improve a board’s ability to negotiate lower advisory fees, among other matters. Moreover, the chairman of the board would be required to be an independent director, which would strengthen the independent nature of a board’s composition and deliberations further still. In addition, the independent directors would be required to meet in separate sessions, at least quarterly, and the independent directors would be authorised to hire their own staff.
Changes for registered investment advisers
As with investment funds, SEC-registered investment advisers must now comply with new proxy-voting rules. Specifically, advisers must adopt and implement policies and procedures to ensure that when they vote or advise others on how to vote proxies, they do so in the best interests of their clients. In addition, advisers must disclose to clients how they can obtain information on the advisers’ voting records, disclose to clients their proxy voting policies and procedures (such as how the advisers will resolve material conflicts of interest with clients) and provide copies of these policies and procedures to clients on request.
Again similarly to its fund rule changes, the SEC has adopted a requirement that registered advisers:
- Implement written compliance policies and procedures that are annually reviewed
- Designate a chief compliance officer
Compliance with this rule is required by 5 October 2004.
Another area of concern for the SEC has been the fiduciary duty of undivided loyalty owed by all registered investment advisers to their clients. The SEC has proposed requiring advisers to adopt and enforce a code of ethics that would establish expected standards of conduct and reflect the adviser’s fiduciary duties. The code of ethics would, among other things:
- Require supervised persons of the adviser to comply with applicable federal securities laws
- Aim to prevent disclosure of material non-public information about the adviser’s securities recommendations and clients’ securities holdings and transactions to persons without ‘need to know’
- Require certain supervised persons (so-called ‘access persons’) to report their personal securities holdings and transactions
- Require access persons to pre-clear any personal investments in initial public offerings or private offerings
- Require supervised persons to report any violation of the code of ethics to the firm’s compliance officer. This proposal is currently subject to public comment until 15 March 2004 (although no specific date for issuance of the final rule has been given)
Hedge funds
Hedge funds are not SEC-regulated differently from any other type of investment fund. As a result, most hedge funds are essentially unregulated because they deal only with customers that are large or wealthy enough to allow the fund to qualify for exemptions from regulation. Nevertheless, the recent rapid growth in investments in hedge funds, which the SEC expects to reach $1 trillion in the near future, has led the SEC to consider whether special hedge fund regulation is warranted. In September 2003, the SEC released Implications of the Growth of Hedge Funds, a non-binding research report in which SEC staff proposed a number of possible methods of hedge fund regulation. Interestingly, the report does not define what is meant by a hedge fund, but instead simply identifies factors common to hedge funds. These include a lack of registration under the federal securities laws and certain commission-based fee arrangements with the fund’s advisers. While such factors are helpful in the first instance, they do not distinguish hedge funds from other similar investment vehicles, such as venture capital funds, private equity funds or commodity pools. The SEC has indicated that it may ultimately turn to the definition of ‘hedge fund’ in the United States Treasury Department antimony laundering rules for direction on how to define the term for securities law purposes (although that definition is extremely broad itself).
At the forefront of changes for hedge funds is the SEC’s proposal to require more hedge fund advisers to register under the Investment Advisers Act of 1940. The consequences of registration under the Investment Advisers Act include being subject to periodic examination by the SEC and being required to implement certain formal compliance and record-keeping measures. The SEC staff has suggested that registration among hedge fund advisers be increased by altering a currently existing exemption from registration so that it fails to apply to most hedge fund advisers. The current exemption allows advisers generally to forego registration if they have fewer than 15 US-based clients. Under the contemplated change, hedge fund advisers would have to ‘look through’ their clients when calculating this number, so as to count as a separate hedge fund client each investor in a direct client. Such a change is likely to require the registration of most hedge fund advisers.
Other proposed changes include measures intended to make hedge funds more transparent to their clients, including the publication and regular updating of a hedge fund ‘brochure’ that would include details regarding compensation arrangements, service arrangements, conflicts of interest, the valuation methods and risk management measures of the adviser, investment strategies and lock-up requirements. Proprietary trading strategies, specific investments and fund clients would not be required to be disclosed as part of the brochure.
The SEC report also proposes certain changes that would probably encourage the growth of the hedge fund industry. For instance, the report proposes allowing funds that rely on section 3(c)(7) Investment Company Act of 1940 to avoid SEC registration, by selling only to large or wealthy ‘qualified purchasers’, to engage in public advertising that reached not only qualified purchasers but also many others. Such ‘general solicitation’ or ‘general advertising’ has long been prohibited in most types of unregistered securities offerings in the US. The report recommends that any such relaxation of the advertising rules would apply to all investment funds that rely on the section 3(c)(7) exemption, including not only hedge funds but also, for example, private equity and venture capital funds.
Other regulatory changes
Of interest to funds and fund advisers, the SEC has also proposed requiring broker-dealers that offer fund participations to customers to provide those customers with specific cost and conflict-of-interest information at two points during a transaction: first, at the point of sale, and second, as part of the transaction confirmation. Essentially, the SEC would require disclosure about revenue sharing arrangements and portfolio brokerage; where brokers or dealers are required or encouraged by arrangements with third parties to market particular funds; and in respect of certain expenses, transaction costs and remuneration. Any order made prior to the point-of-sale disclosure would be deemed to be a non-binding indication of interest that could be cancelled or abandoned by the customer without penalty.
Philip Ferrera, is an associate, US corporate finance group at Norton Rose. He advises on equity and debt offerings, listing requirements and ongoing reporting and securities compliance requirements, mergers and acquisitions and private placements as an associate in the US corporate finance group at Norton Rose. He also advises on Investment Company Act and Investment Advisers Act registration for both US and non-US entities.
This article originally appeared in International Securities Quarterly, Issue 30, March 04