REGULATORY CHALLENGES AND OPPORTUNITIES FOR HEDGE FUNDS IN THE U.S. AND EUROPE

PATRICIA A. POGLINCO • ROBERT VAN GROVER

ONE BATTERY PARK PLAZANEW YORK, N.Y. 10004

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www.sewkis.com

Administration Proposal for Financial Regulatory Reform

• Released on June 17, 2009

• Designed to restore confidence in U.S. financial system following financial crisis

• Proposed reforms target all aspects of financial system – including hedge funds and derivatives

• Most comprehensive proposed financial services legislation since the passage of the securities laws

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Five Key Objectives

• Promote robust supervision and regulation of financial firms

• Establish comprehensive supervision of financial markets

• Protect consumers and investors from financial abuse

• Provide the government with tools needed to manage financial crises

• Raise international regulatory standards and improve international cooperation

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Robust Supervision of all Financial Firms

• Creation of Financial Services Oversight Council (FSOC)

– Replaces the President’s Working Group on Financial Markets

– Mandate is to identify emerging risks and advise Federal Reserve on potential problem firms

– Chaired by Secretary of Treasury; members of council should include: Chairman of the Board of Governors of the Federal Reserve, Director of the National Bank Supervisor, Director of the Consumer Financial Protection Agency, Chairman of the SEC, Chairman of the CFTC, Chairman of the FDIC and Director of the Federal Housing Finance Agency

– FSOC to have permanent staff at Treasury Department

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Consolidated Supervision and Regulation of Certain Financial Firms

• All financial firms found to pose a threat to financial stability based on size, leverage and interconnectedness will be classified as Tier 1 FHCs and subject to consolidated supervision and more strict regulation

• The Federal Reserve will identify those firms that should be classified as Tier 1 FHCs (based in part on recommendations from the FSOC)

• Tier 1 FHCs will include those private pooled vehicles (individually or collectively) that meet the established criteria

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Consolidated Supervision and Regulation of Certain Financial Firms

• Congress will be directed to establish factors that the Federal Reserve must consider when making the determination that a financial firm should be classified as a Tier 1 FHC including:

– Impact firm’s failure would have on the financial system and the economy

– Firm’s combination of size, leverage (including off-balance sheet exposure) and degree of reliance on short-term funding

– Firm’s importance as source of credit for households, businesses and state and local governments and as source of liquidity for financial system

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Additional Federal Reserve Powers

• To collect information (periodic and other reports) from all financial firms that meet certain size thresholds

• Access to financial firm reports submitted to other regulators (e.g., SEC or CFTC)

• Authority to require reports and conduct examinations of

Tier 1 FHCs and their subsidiaries even though the entities may be supervised by other regulatory agencies

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Prudential Standards for Tier 1 FHCs

• Capital requirements• Prompt corrective action• Liquidity standards• Overall risk management• Market discipline and disclosures• Restrictions on non-financial activities• Rapid resolution plans

In consultation with the FSOC, the Federal Reserve will establish “prudential standards” for Tier 1 FHCs

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Restrictions on Non-Financial Activities

• Tier 1 FHCs would be subject to the nonfinancial activities restrictions of the Bank Holding Company Act

• Such restrictions may include a prohibition that prevents a Tier 1 FHC from acquiring more than 5% of the outstanding shares of a company unless such company is engaged in financial activities or activities incidental to a financial activity

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Registration of Advisers to Hedge Fund and Other Private Pools of Capital

• Proposal would require all advisers to private pools of capital whose assets exceed a modest threshold to register with the SEC – hedge funds– private equity funds– venture capital funds

• Possible required disclosures to investors, creditors and counterparties

• SEC recordkeeping requirements would extend to investment funds managed by SEC-registered advisers

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Reporting Requirements forRegistered Advisers

• Registered Advisers would be required to report information about the private funds that they manage sufficient to enable regulators to assess the threat to financial stability

• Reporting should be confidential and include:– amount of assets under management– borrowings– off balance sheet exposures

• SEC should share information with the Federal Reserve to be used to determine whether any fund or families of funds meet the Tier 1 FHC criteria

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Strengthening Regulation of Core Markets and Market Infrastructure

• Strengthen supervision of securitization markets

• Originator of securitized loan (or sponsor of securitization) must retain 5% of credit risk of securitized exposures

• SEC will have the authority to require robust reporting by ABS issuers

• SEC will continue to tighten regulation of credit rating agencies

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Comprehensive Regulation of Markets for Over-the-Counter Derivatives (including Credit Default Swaps)

• Transparency for all OTC derivatives trades through recordkeeping and reporting

• Standardized OTC derivatives to be centrally cleared and executed on exchanges and other transparent trading venues

• Higher capital charges for customized OTC derivatives

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Harmonized Futures andSecurities Regulation

• SEC and CFTC must make recommendations to eliminate differences in statutes and regulations with respect to similar types of financial instruments– For example, many financial options and futures products are

similar, yet options are regulated by the SEC whereas futures contracts on the same underlying security are regulated jointly by the SEC and CFTC

• Provide joint report to Congress by September 30, 2009

• If SEC and CFTC cannot agree by September 30, 2009 the Financial Services Oversight Council will make recommendations to resolve the differences within 6 months of its formation

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Providing Government with Tools to Effectively Manage Financial Crises

• More stringent capital, activities and liquidity requirements will be imposed on Tier 1 FHCs

• Prompt corrective action will be required from Tier 1 FHCs to address declining capital levels

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Special Resolution Regime

• Tier 1 FHCs to maintain rapid resolution plans to be implemented in the event of severe financial distress

• Federal Government to be given emergency authority to resolve Tier 1 FHCs in an orderly manner

• Treasury Department would invoke this authority in consultation with the President and written recommendation of 2/3 of the members of the Federal Reserve Board and the appropriate regulatory agency that supervises such Tier 1 FHC

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Special Resolution Regime

• Treasury Department authority would include appointment of a receiver or conservator

• Generally, the Treasury Department should appoint the FDIC or SEC as the receiver or conservator

• Receiver or conservator should have the authority to take control of firm operations, sell or transfer firm assets, transfer a firm’s derivative transactions, renegotiate or repudiate firm contracts and borrow from the Treasury Department

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Strengthening Consumer Protection

• Creation of Consumer Financial Protection Agency (CFPA) with authority to protect consumers of credit, savings, payment and other consumer financial products and services and regulate providers of these products and services (other than those regulated by the SEC or CFTC)

• CFPA would be authorized to reform mortgage laws

• Place banks, nonbanks and independent mortgage brokers on a level playing field – activities would be regulated regardless of whether it is a financial institution

• Consumer Financial Protection Agency Act of 2009 establishing the Consumer Financial Protection Agency referred to House Committee on Financial Services and Committee on Energy and Commerce on July 8, 2009

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SEC Focus on Transparency, Fairness and Accountability

• SEC should be authorized to require certain disclosures to investors at or before certain sales of financial products

• Harmonize regulation of broker-dealers that offer investment advice and investment advisers

• Improve accountability of financial firms and public companies

• On July 10, 2009, the Administration proposed the Investor Protection Act of 2009

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Improve International Regulatory Standards and Cooperation

• Subject foreign firms operating in the U.S. to the same regulation and oversight as U.S. firms that pose a risk to the U.S. financial systems

• Reach an international consensus regarding capital standards, oversight of OTC derivatives markets, supervision of internationally active financial firms and crisis prevention procedures

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What Does it All Mean?

• Unprecedented authority proposed for the Federal Reserve

• “Power Grab” by Federal Banking authorities?

• Unclear how differing regulatory mandates will be handled– SEC has mandate of investor protection and ensuring the

integrity and efficiency of financial markets– CFTC has mandate of encouraging competitiveness of futures

markets, investor protection and ensuring integrity of the clearing process

– Bank regulators have mandate of ensuring safety and soundness of particular institutions

– Federal Reserve acts as the central bank and has overall responsibility for supervising and regulating segments of the banking industry to ensure safe and sound banking practices and compliance with banking laws

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Related Legislative Hearings

• June 18, 2009: Senate Committee on Banking, Housing and Urban Affairs Hearing on the Administration’s Proposal to Modernize the Financial Regulatory System

• July 8, 2009: House Subcommittee on Commerce, Trade and Consumer Protection Hearing on The Proposed Consumer Financial Protection Agency: Implications for Consumers and FTC

• July 9, 2009: House Committee on Domestic Monetary Policy and Technology Hearing on Regulatory Restructuring: Balancing the Independence of the Federal Reserve in Monetary Policy with Systemic Risk Regulation

• July 10, 2009: House Agricultural Committee and Financial Services Committee Hearing on a Review of the Administration's Proposal to Regulate the Over-the-Counter Derivatives Market

• July 13, 2009: House Committee on Financial Services Hearings on proposed Financial Regulatory Reform (postponed)

• July 15, 2009 - July 17, 2009: House Committee on Financial Services Hearings on proposed Financial Regulatory Reform

• July 15, 2009: Senate Committee on Banking, Housing and Urban Affairs on regulating hedge funds and other private investment pools

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Hedge Fund Adviser Registration Act of 2009 (H.R. 711)

• Proposed January 27, 2009

• Proposal to amend the Investment Advisers Act of 1940– Would remove Section 203(b)(3) of the Advisers Act (current

exemption for investment advisers with fewer than 15 clients)

• Result: Investment advisers with $30 million or more in assets under management would be required to register with the SEC

• Status: Referred to the House Committee on Financial Services on January 27, 2009

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Hedge Fund Transparency Act (S. 344)

• Proposed January 29, 2009

• Proposal to amend the Investment Company Act of 1940– Private funds (including hedge funds, private equity funds and venture capital

funds) with $50 million or more in assets under management would be required to register with the SEC and comply with certain requirements in order to remain exempt from substantive provisions of the Investment Company Act

• Requirements include:– Maintenance of books and records required by the SEC– Cooperate with any request for information or examination by the SEC– Establish an anti-money laundering program– File an annual information form electronically with the SEC (to be made publicly

available)

• Status: Referred to the House Committee on Banking, Housing and Urban Affairs on January 29, 2009

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Private Fund Transparency Act of 2009 (S. 1276)

• Proposed June 16, 2009

• Proposal to amend the Investment Advisers Act of 1940– Would replace the current private investment adviser exemption with a

more limited exemption available only to certain foreign private investment advisers with no place of business in the U.S. and less than $25 million in assets attributable to clients in the U.S.

– SEC would be authorized to collect risk data, records and reports from registered advisers

• Result: All U.S. investment advisers with at $30 million or more in assets under management would be required to register with the SEC

• Status: Referred to House Committee on Banking, Housing and Urban Affairs on June 16, 2009

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Significant U.S. Federal Income Tax Developments

• Sen. Levin’s Bill (S. 506)– Treats foreign corporations, including offshore hedge funds, with

gross assets of $50 million or more as U.S. corporations if “management and control” of the corporation occurs primarily within the U.S. (i.e., investment decisions are made within the U.S.)

– Subjects dividend equivalent payments received by foreign persons with respect to total return swaps and other derivatives referencing U.S. corporation stock to a 30% U.S. withholding tax.

– Status: Referred to Senate Finance Committee on

March 2, 2009

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Significant U.S. Federal Income Tax Developments

• Rep. Rangel’s Bill (H.R. 3970)– Treats partnership income earned for providing investment

management services (i.e., carried interest) as ordinary income– Status: Referred to House Ways and Means Committee on

October 25, 2007

• Administration’s Revenue Proposals– Effective in 2011, “carried interest” (e.g., incentive or profit

allocations) would be taxed as ordinary income (likely would also subject carried interest to self-employment tax)

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Significant U.S. Federal IncomeTax Developments

• Rep. Levin’s Bills

– H.R. 3501

• Creates an exception to the unrelated debt-financed income rules that would allow U.S. tax-exempt entities to invest directly in domestic hedge funds (rather than through foreign blocker corporations) without incurring UBTI

• Status: Referred to House Ways and Means Committee on September 7, 2007

– H.R. 1935

• Treats income from an “investment services partnership interest” (i.e., interest in a partnership held by a person providing investment management services to the partnership) as ordinary income and subject to self-employment tax

• Status: Referred to House Ways and Means Committee on April 2, 2009

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