Tag: SEC

Senate Passes Sweeping Patent Reform Legislation

Recently posted in the National Law Review an article by Linda C. Emery, Mark F. Foley, Alexander M. Gerasimow, and Gottlieb John Marmet regarding the new legislation on September 8, 2011  designed to significantly overhall the US patent system:  

 

The U. S. Senate passed sweeping legislation on September 8, 2011, designed to significantly overhaul the U.S. patent system. The Leahy-Smith America Invents Act (“Act”) (HR 1249) makes numerous changes to the U.S. patent laws, most notably conforming U.S. patent law to the laws of most other countries by granting patent protection to the first person to file for patent protection rather than the first to invent, as it is now. Portions of the Act will take effect immediately, while others will become effective in 12 to 18 months. President Obama is expected to sign the bill into law promptly.

Other notable changes to the patent laws include:

  • Third parties are given the opportunity to challenge the Patent Office’s decision to grant a patent.
  • Third parties may cite prior art to the Patent Office during prosecution of a patent application.
  • Strategies to reduce taxes are not patentable.
  • Only the government and those suffering a competitive injury will be allowed to sue for false patent marking.
  • Failure to obtain the advice of counsel cannot be used to prove willful infringement.
  • Creates a mechanism by which the Patent Office will reevaluate and possibly invalidate previously issued business method patents.
  • Eliminates the requirement that inventors describe the “best mode” of making and using the invention as a basis for challenging the validity of a patent.
  • Allows individual inventors or very small companies to file patent applications at significantly lower fees, allowing those small companies and inventors to afford filing a patent application where they might not otherwise be able to afford such an application.

Companies and individuals who already have patents or pending patent applications should review their current practices and bring them in-line with the new patent laws in order to maintain their competitive edge. Inventors should also file an application as soon as possible, and must take additional steps to avoid disclosure or commercialization of their inventions prior to filing a patent application or risk losing the right to seek patent protection.

©2011 von Briesen & Roper, s.c

D.C. Circuit Invalidates SEC's Proxy Access Rules

Posted on Sunday, July 24, 2011 in the National Law Review an article by John D. Tishler  and Evan Mendelsohn of Sheppard, Mullin, Richter & Hampton LLP regarding the  United States Court of Appeals for the District of Columbia Circuit’s decision invalidating the SEC’s proxy access rules adopted in August 2010:

July 22, in Business Roundtable v. Securities & Exchange Commission, No. 10-1305 (D.C. Cir. July 22, 2011), the United States Court of Appeals for the District of Columbia Circuit issued its decision invalidating the SEC’s proxy access rules adopted in August 2010 with the intention that they be effective for the 2011 proxy season (see our blog here). The Business Roundtable and U.S. Chamber of Commerce filed the lawsuit in September 2010 challenging the SEC’s adoption of proxy access rules and separately requesting for the SEC to stay implementation of the rules pending the outcome of the lawsuit. The SEC granted the request for stay in October 2010 and issuers were relieved of the burdens of proxy access for the 2011 proxy season. (See our blog posts here and here.)

The Court found that the Commission “neglected its statutory responsibility to determine the likely economic consequences of Rule 14a-11 and to connect those consequences to efficiency, competition, and capital formation.” The Court also criticized the SEC’s reliance on empirical data that purported to demonstrate that proxy access would improve board performance and increase shareholder value by facilitating the election of dissident nominees, pointing out numerous studies submitted in the rule comment process that reached the opposite result.

The SEC’s proxy access rules also included an amendment to Rule 14a-8 that would authorize stockholder proposals to establish a procedure for stockholders to nominate directors. The SEC stayed implementation of the changes to Rule 14a-8 at the same time it stayed implementation of Rule 14a-11; however, the changes to Rule 14a-8 were not affected by the Court’s decision.

The SEC will now need to decide whether to propose new regulations for proxy access and whether to permit Rule 14a-8 to go effective.  However the SEC decides to proceed, it seems unlikely that public companies will face mandatory proxy access for the 2012 proxy season. 

Copyright © 2011, Sheppard Mullin Richter & Hampton LLP.

Collision Occurs Between Copyrights and Misappropriation in Electronic News Media Space

Posted this week at the National Law Review by Bracewell & Giuliani LLP  and interesting article about copyrightable aspects of Wall Street research—the published models, insights, and facts:   

Despite winning in court to protect valuable copyrights, Wall Street firms are unable to protect their valuable trading recommendations as federal and state laws collide in Barclays Capital Inc. v. Theflyonthewall.com, Inc.1 (pending any potential review on appeal). The electronic news media continues to lead the charge, and now the walls of exclusivity are beginning to crumble for these respected recommendations.

Wall Street firms have for long provided detailed research reports and trading recommendations—exclusively to firm customers—to drive order flow with the recommending firm, thereby generating commission revenue. Storming the walls, however, are those in the electronic news media blasting the once-exclusive information to all corners of the Internet, immediately upon its release by Wall Street. But for Wall Street, this widespread, uncontrolled dissemination has cut into profitability and has wreaked havoc on traditional business models for market research.

Although the electronic news media scored a fresh victory, Wall Street has not suffered a devastating loss. The copyrightable aspects of Wall Street research—the published models, insights, and facts, for example, are often more valuable to institutional customers than the basic recommendation itself (e.g., Buy, Sell, or Hold). These copyrightable aspects, of course, remain protected by federal copyright law.2 Outside the realm of finance, however, this case may signal much broader implications for any business with both feet in the Information Age.

The appeals court received this case after the District Court for the Southern District of New York granted injunctive relief to plaintiffs Barclays Capital Inc.; Merrill Lynch; Pierce, Fenner & Smith Inc.; and Morgan Stanley & Co. Inc. (“the Firms”), which prohibited Theflyonthewall.com, Inc. (“Fly”) from publishing information about the Firms’ recommendations, within certain parameters.3 The issue presented on appeal was whether Fly could be enjoined from publishing “news,” i.e., bare facts, that the Firms [had] made certain recommendations.4 The appeals court vacated the injunction, paving the way for the electronic news media to publish Wall Street recommendations far and wide, and of course, to direct profits to publishers and sponsors, away from the recommending firm. In the wake of this decision, Wall Street firms must now reconsider business models built upon the value of their proprietary information.

Without further recourse from federal copyright law, which does not protect bare “facts” alone, the Firms sought relief under New York tort law through the doctrine of “hot news” misappropriation of information. The appeals court was bound to consider, however, whether federal copyright law preempted the applicability of state law in these circumstances. To survive preemption, Firms were required to prove that Fly’s use of the information constitutes “free riding” on the Firms’ efforts.5 By concluding that there was no “free riding,” the appeals court significantly narrowed the circumstances in which similar state law misappropriation claims can survive preemption by federal copyright law. Accordingly, this case signals a broader victory for electronic publishers hoping to widely distribute, and to profit from, factual information created by others.

In determining whether Fly engaged in “free riding,” the court looked to precedent in National Basketball Association v. Motorola, Inc.6 (“the NBA Case”). In the NBA Case, the NBA collected and broadcast information, based on live sports games, over a communication network; and likewise, a competitor collected and broadcast its own information, based on live sports games, over a competing communication network. The appeals court noted that, in the NBA Case, there was no free riding, in part, because Motorola was bearing its own costs of collecting factual information.

In the present case, the appeals court’s ultimate inquiry was whether any of the Firms’ products enabled Fly “to produce a directly competitive product for less money because it has lower costs.”7 Extending the reasoning from the NBA Case to cover Fly’s actions, the appeals court concluded that that there was no “free riding” because approximately half of Fly’s twenty-eight employees were involved in the collection and distribution of Firms’ recommendations.8 According to the appeals court, Fly “is reporting financial news—factual information on Firm Recommendations—through a substantial organizational effort.”9

The appeals court, however, did not consider it important that the Firms had incurred substantial costs in research and analysis (i.e., acquiring and creating information) as the basis for their recommendations, whereas Fly’s only costs were in collecting and reporting the recommendations. The appeals court discarded the relevance of these basis costs—even though they provide an arguable distinction over the NBA Case—stating that although the Firms “may be ‘acquiring material’ in the course of preparing their reports . . . that is not the focus of this lawsuit. In pressing a ‘hot news’ claim against [Fly], [Firms] seek only to protect their Recommendations, something they create using their expertise and experience rather than acquire through efforts akin to reporting.”10 The appeals court concluded that there was no meaningful difference between “taking material that a Firm has created . . . as the result of organization and the expenditure of labor, skill, and money . . . and selling it by ascribing the material to its creator” and the “unexceptional and easily recognized behavior by members of the traditional news media [reporting on] winners of Tony Awards . . . with proper attribution of the material to its creator.”11 We expect that the contours of these differences to be a key issue if this case [is] heard on appeal, either at the Second Circuit en banc or at the United States Supreme Court.

Absent any legal recourse to ensure the exclusivity of their recommendations, Wall Street firms must now scramble to implement even greater security and counter-intelligence measures. After all, publishers such as Fly rely on information leaks and intelligence to timely obtain the recommendations in the first place. More likely, however, is that Wall Street firms will soon refine their business models to otherwise adequately monetize, or else reduce expenditures in, their intensive research and analysis efforts.

The broader implications of this case—that the “ability to make news . . . does not give rise to a right for it to control who breaks that news and how”12—will bear critically on the development, funding, and overall power of rapidly-advancing electronic information sources. In particular, businesses providing information aggregation services of all stripes—including, for example, those provided by Google, Inc. and Twitter, Inc.—will rejoice in the ability to gather and publish information from multiple sources across the entire nation with a lower risk of encountering divergent legal standards for misappropriation, on a state-by-state basis.

____________________

1 Barclays Capital Inc. v. Theflyonthewall.com, Inc., No. 10-1372-cv (2d Cir. June 20, 2011).
2 The District Court for the Southern District of New York awarded monetary relief for copyright infringement by Fly’s unauthorized distribution of the Firm’s actual reports. Issues concerning copyright infringement were not addressed on appeal.
3 The injunction allowed the Firms’ customers to trade on the Firms’ recommendations prior to the broader market. The injunction prohibited Fly from reporting a recommendation until (a) the later of one half-hour after the opening of the New York Stock Exchange or 10:00 am for those recommendations first distributed prior to 9:30 am, or (b) two hours after the recommendation is first distributed by one of the Firms to its clients, for those recommendations first distributed at or after 9:30 am on a given day. See Barclays Capital Inc. v. Theflyonthewall.com, Inc., slip op. at 29, n.20.
4 For example, a headline covering one of the Firms’ recommendations may state: “EQIX initiated with a Buy at BofA/Merrill. Target $110.”
5 “Free riding” was but one factor in a five-pronged test, the remainder of which were not the basis of the decision. The appeals court speculated, however, that proving certain other factors may be troublesome, such as “direct competition” between Fly and the Firms.
6 105 17 F.3d 841 (2d Cir. 1997).
7 Barclays Capital Inc. v. Theflyonthewall.com, Inc., slip op. at 67.
8Fly previously relied on employees at investment firms (without the firms’ authorization) to e-mail the research reports to Fly as they were released. Fly’s staff would summarize a recommendation as a headline, and sometimes, Fly would include in a published item an extended passage taken verbatim from the underlying report.  Fly maintains that it no longer obtains recommendations directly from such investment firms and, instead, that it gathers them using a combination of other news outlets, chat rooms, “blast IMs” sent by people in the investment community to hundreds of recipients, and conversations with traders, money managers, and its other contacts involved in the securities markets. Id. at 16-17.
9 Id. at 67.
10 Id. at 62.
11 Id. at 63-64.
12 Id. at 71.

© 2011 Bracewell & Giuliani LLP

An Overview of the Hedge Fund Industry and What’s Coming Next for Hedge Funds

The National Law Review‘s  winner of the Fall Student Legal Writing Contest is Karol C. Sierra-Yanez of Suffolk University Law School. Karol’s article provides some background on the hedge fund industry and where experts think regulation of this industry may be going.  Read on: 

This paper aims to provide the reader with a better understanding of what the term hedge fund means, their history and development, and how hedge funds differ from traditional investment vehicles, such as mutual funds. It will focus on the future of the hedge fund industry, specifically, the changes proposed in the Hedge Fund Transparency Act. While some critics and experts in the financial industry see this Act as a way to regulate an investment vehicle capable of affecting the economy, others see it as an invasion into the freedom of hedge fund advisers to develop creative strategies to hedge the risks of their investments and enhance returns.

I. WHAT IS A HEDGE FUND?

To begin with, there is no universally accepted definition of hedge funds. The various definitions refer to hedge funds as private investment vehicles that are subject to less regulation in comparison with more traditional forms of investment, such as mutual funds.[1] Hedge funds are not defined by the Securities and Exchange Commission (SEC), in fact, there is no regulatory or statutory definition of hedge funds.[2]

While the first hedge fund was started in 1949 when Alfred W. Jones developed a system to protect investments against market risk[3] that incorporated various techniques including the use of leverage[4] and short selling[5], other financially creative hedge fund managers also came along and developed new hedging strategies such as the use of futures and options, strategies that did not exist when Jones developed his fund.[6] With the use of these new strategies, hedge funds started to generate favorable returns again and increasingly grew in popularity, to the point that by 2002, there were an estimated 6,500 hedge funds operating in the United States, managing approximately $600 billion in capital.[7]

II. HOW DO HEDGE FUNDS DIFFER FROM TRADITIONAL INVESTMENTS?

To begin, a major characteristic difference between hedge funds and mutual funds is that mutual funds and their managers are required to register with the United States Securities and Exchange Commission (SEC), whereas hedge funds are unregistered investment vehicles. [8] Mutual funds must register as investment companies under the Investment Company Act of 1940 and their managers must register under the Investment Advisers Act of 1940[9]; these funds are considered to be “public” investment funds, meaning they are open to the general public and any investor possessing the required capital may invest, regardless of their net worth or level of sophistication. [10] Hedge funds, on the other hand, are considered “private” investment funds, and are not registered with any government body, and are only open to qualified or accredited investors, including high-net-worth investors, institutions, endowments, family offices and pension programs.[11]

From a sales and marketing standpoint, mutual funds can be purchased in any number of ways, with common examples including directly through a fund management company (e.g. Fidelity), through a mutual fund ‘supermarket’ (e.g. Charles Schwab) or through a broker or financial planner (e.g. Ameriprise Financial).[12] Advertisements for mutual funds can often be found in a variety of published sources, including magazines, newspapers, and on the internet.[13]Hedge funds, meanwhile, are much different in terms of sales and marketing; to be free from certain restrictions, “hedge funds limit access to investors who regulators deem rich and savvy enough to handle the risk.”[14] This is closely related to the fact that hedge funds are referred to as “private placement” vehicles, which refers to the offer and sale of a security not involving a public offering and therefore not subject to filing a registration statement with the SEC under the Securities Act of 1933.[15]

From the standpoint of fees and expenses, mutual funds have what is called an “expense ratio”, which is the percentage of fees paid by investors to the company to cover the costs of managing and operating the fund, as well as marketing and distribution costs. [16] The expense ratio is the total fee that the investor will pay, besides any transaction costs that are incurred at the time of purchase or sale of the shares.[17] The average equity mutual fund charges an expense ratio somewhere between 1.3% and 1.5%. [18] Hedge funds, meanwhile, in addition to a management fee (similar to the expense ratio of mutual funds), also charge a percentage of profits earned by the fund. [19]The popular fee arrangement in the hedge fund industry, commonly referred to as “2 & 20”, is to charge 2% of assets under management (the management fee) as well as 20% of profits over a stated benchmark (the performance or incentive fee). [20]

Any person who possesses the required capital is generally allowed to invest in the mutual fund of their choice, and most funds have a minimum investment of $1000, making them a relatively accessible investment for most people.[21] In addition, mutual funds stand ready to redeem an investor’s shares at any point in time, a concept called liquidity, making it relatively easy for an investor to get their money back when they would like.[22] Minimum investments for hedge funds are quite steep, and vary from fund to fund, ranging from $100,000 to $1,000,000 or more. [23] Liquidity, or the ability of an asset to be converted into cash quickly,[24]is quite different between hedge funds and mutual funds. With mutual funds, a net asset value (or “NAV”) is computed every single business day, and investors can redeem their shares at the NAV on a daily basis. [25] Based on a review of several articles, with hedge funds, like mutual funds, the liquidity depends on the frequency with which they issue and redeem shares, but just much less frequently. Most hedge funds have monthly liquidity with a 35-day notice period, but some are much less liquid, depending on the type of assets invested in and the strategies employed by the fund.[26] Hedge funds are also subject to a “lock-up period”[27], which is the time period that an investor must hold their assets within a fund before they can be removed. In other words, mutual fund shares have a readily ascertainable market and a fair price, while hedge fund investors have a contract with the manager that essentially allows the manager to dictate the frequency and manner of redemption.[28]

Traditional mutual funds are generally segmented into a few basic categories, such as stock (growth, value, blend), bond (municipal, corporate, government), and money market (cash, t-bills),[29] according to the types of investments they will make as outlined in their prospectus. They do not deviate from their prescribed investment approach, and are generally limited to the types of investments they can make.  Hedge funds, however, generally employ sophisticated trading methods, including short selling (when the investor sells borrowed securities), options (financial contracts between two parties), and leverage (the use of borrowed capital to purchase additional assets with the objective of increasing returns). [30]

According to a Morningstar Methodology Paper published in 2007 titled “The Morningstar Category Classifications for Hedge Funds”, hedge fund managers typically focus on specific areas of the market and/or specific trading strategies. Morningstar states, as an example, “that some hedge funds buy stocks based on broad economic trends, while others search for arbitrage profits by pairing long and short positions in related securities.”[31]

III. PRESENT REGULATORY FRAMEWORK

As discussed briefly in the section outlining the key differences between hedge funds and more traditional investment vehicles, regulatory differences, most of which stem from the fact that participation in hedge funds is mainly the “preserve of sophisticated investors who possess the required knowledge to assess the risks associated with investing in this asset class”[32] are of the utmost importance. Under this sophistication premise, it is maintained that wealthy investors can better fend for themselves[33] and are thus more suited for hedge fund investments, whereas the everyday, less sophisticated investor may not be.

Two of the primary statutory exclusions for hedge funds from the definition of “Investment Company” come from the Investment Company Act of 1940: §3(c)(1) and §3(c)(7).[34] The §3(c)(1) exemption is satisfied when the issuer sells their securities to no more than 100 persons and does not make or will not plan to make a public offering of those securities;[35] the §3(c)(7) exemption, meanwhile, is satisfied when the securities are being sold only to “qualified purchasers” and also like §3(c)(1) the issuer does not make or does not plan to make a public offering of those securities. As one may note, §3(c)(7) makes no reference to the number of investors in a fund in the manner that §3(c)(1) does, and this is where the Securities Exchange Act of 1934 comes into play. Under §12(g) of the Exchange Act, it states that an issuer must “register, disclose information and submit periodic reporting” if the issuer has $10 million or more in assets under management and 500 or more investors.[36] Due to this fact, it comes as no surprise that many hedge funds elect to issue securities to less than 500 investors in order to avoid triggering this requirement.[37] Similarly, those fund managers that operate as Commodity Pool Operators (“CPO”) are able to rely on regulations contained in the Commodity Exchange Act (“CEA”) that “provide an exemption from registration to CPOs that engage in limited commodity futures activities and sell interests solely to certain qualified individuals and that sell interests to highly sophisticated pool participants.[38]

Finally, the Investment Advisers Act of 1940 (not to be confused with the Investment Company Act of 1940), which regulates the activities of investment advisers, also contains one registration exemption that hedge funds commonly rely upon. The registration exemption is called the “private adviser exemption” and is found under §203(b) of the Advisers Act and states that the exemption is satisfied if the adviser “1) has fewer than fifteen clients during the preceding twelve months; 2) [nor] holds himself out to the public as an investment adviser nor acts as an investment adviser to any investment company.”[39] This exemption at first may seem rather difficult to achieve, as it would seem that most hedge funds would have 15 or more investors, but there is a catch. Under the law, hedge fund advisers are able to meet this exemption by satisfying a safe harbor whereby they treat each legal entity (e.g. a single fund, limited partnership, etc) as a single client and are able to invoke the small adviser exemption.[40] As such, many hedge fund advisers avoid registering with the SEC by relying on this de minimis exemption and have fewer than 15 “clients” during the preceding 12 months and do not hold themselves out to the public as investment advisers.[41] This specific exemption will be touched upon further in the paper as it has been the focal point of recent regulation changes affecting the hedge fund industry.

IV. PAST PROPOSED HEDGE FUND REGULATIONS

While hedge funds themselves have been around for decades, they did not grow to such prominence until much more recently. For example, during the post-technology bear market era around 2000 through late 2002 the popularity of hedge funds grew very quickly, and by 2006 there were approximately 8,000 hedge funds globally with assets under management in excess of $1 trillion compared to 1990 when there were only 600 hedge funds with under $40 billion in combined assets under management.[42]

This tremendous outgrowth, which directly results in a significant amount of power and influence within the capital markets, is one of the factors often cited by the SEC as rationale for regulatory action against the hedge fund industry. Other factors include the fact that government agencies generally lack meaningful and reliable data and information about the hedge fund industry as well as the increased “retailization” of hedge funds.[43] An example of such “retailization” would be the fact that U.S. hedge fund of funds that do not meet the aforementioned exemptions and are registered with the SEC do not need to require that all investors be accredited and may accept investments for as little as $25,000.[44] Pension plans, university endowments, and charitable organizations have been investing money in hedge funds, sometimes exposing unsophisticated investors to risky investment strategies.[45] This has led to concerns that unsophisticated investors have invested in vehicles they do not understand.[46]Besides, some hedge funds have been using television commercials to advertise their investment services to unsophisticated investors.[47]

In response to these factors, a 2003 SEC Staff Report investigated the hedge fund industry and concluded that the SEC should require hedge fund advisers to register under the Advisers Act.[48] The SEC had concluded that a number of existing hedge funds were using the private adviser exemption in contradiction of its intended purpose and that a change of the interpretation of the term “client” was justified.[49] Accordingly, in 2004, the SEC, by a vote of 3-2, adopted regulation 203(b)(3)-2, which was an amendment to §203(b)(2) of the Advisers Act, which would require many hedge fund advisers to register with the SEC for the first time.[50] This amendment is referred to as the 2004 Hedge Fund Rule, and defined each investor within a private hedge fund as a “client” for the purpose of determining whether the adviser satisfied the previously discussed private adviser exemption.[51] This Rule applied a “look-through” to hedge funds (in contrast to the previously mentioned safe harbor rule which counted each fund or legal entity as a “client”), whereby each individual investor would be counted as one client, thereby many hedge fund advisers were no longer able to satisfy the private adviser exemption under the Advisors Act and were legally required to register with the SEC.[52] Not surprisingly, the SEC, in support of the passing of this amendment, argued that the registration of hedge fund advisers is necessary “to protect investors in hedge funds and to enhance the Commission’s ability to protect our nation’s securities markets.”[53]

It seemed, however, that from the very beginning there were those who felt the passing of the “Hedge Fund Rule” would do little to no good in actually improving the hedge fund industry. One of the articles used for this research states that “the implementation of this mandatory disclosure will probably have little or no impact in practice” and even continues by saying that “the implementation of this rule might ultimately be counterproductive to the SEC’s goal of the abolishment of the “retailization” of hedge funds.[54]

Unfortunately for the SEC, their efforts aimed at hedge fund regulation were short-lived, as in 2004 hedge fund manager Philip Goldstein, his firm Opportunity Partners LLC, and their general partner Kimball & Winthrop filed suit against the SEC, arguing that the “Commission lacked any power to regulate the hedge fund advisor industry and that only Congress may change the Advisers Act.[55] In doing so, Goldstein et al challenged the enforcement of the recently passed Hedge Fund Rule, arguing that Congress “unambiguously intended the term “client” to mean the fund, and not the investors in the fund.[56] The challenge also claimed that the SEC “drastically exceeded the term’s “probability of meaning” and the SEC’s adoption of the rule was arbitrary and capricious.[57] A three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit heard arguments in the case of Goldstein v. SEC, and in 2006 they vacated and remanded the Hedge Fund Rule and held that the SEC’s interpretation of the word “client” was “outside the founds of reasonableness”, “arbitrary” and “inconsistent with Congressional intent.”[58] Adding insult to injury, the court even went as far as to say that “the Hedge Fund Rule came close to violating the plain language of the Advisers Act.”[59]

V. RECENTLY PROPOSED HEDGE FUND REGULATIONS

Despite a lack of early success, the U.S Government did not give up on the subject of hedge fund industry regulation. Looking back at the many concerns related to the hedge fund industry and the financial industry overall, the use of the term “systemic risk” has become rather commonplace when describing the perceived risk inherent in hedge funds. In a paper entitled “Unnecessary Reform: The Fallacies With and Alternatives to SEC Regulation of Hedge Funds”, author Evan M. Gilbert defines systemic risk as “the potential for a modest economic shock to induce substantial volatility in asset prices, significant reductions in corporate liquidity, potential bankruptcies and efficiency losses.”[60] Many including regulators are concerned that the sudden and powerful downfall of large and influential investment funds and/or firms could have drastic and far-reaching effects throughout the entire financial system.

As such, and particularly in the wake of the financial crisis that occurred between 2007 and 2008, regulators sprung into action in 2009 and quickly introduced new measures aimed at the hedge fund industry. The first came on January 29, 2009, when two United States politicians, Senators Chuck Grassley of Iowa and Carl Levin of Michigan, introduced the “Hedge Fund Transparency Act of 2009.” This act would amend the Investment Company Act of 1940 and aim to regulate hedge funds in two specific ways: first, it would require any funds with assets equal to or greater than $50 million to register with the SEC and second it would impose more stringent anti-money laundering obligations.[61] The Act would encompass all §3(c)(1) and §3(c)(7) exempted funds, not just “hedge funds” per se; as such, all privately-held investment funds ranging from hedge funds to venture capital and private equity funds would be affected.[62]

As mentioned, all “large” funds with $50 million or more in assets would be required to register with the SEC; in addition, they would be required to maintain books and records with the SEC, and also comply with any requests for information or examination by the SEC.[63] Finally, periodic electronic reporting (minimum once per year) to the SEC would also be required of all funds.

Besides the Hedge Fund Transparency Act of 2009, other regulatory developments were underway in 2009. In a paper published in March, 2010 entitled “New Developments in Securities Litigation”, author Elizabeth P. Gray, a partner at Willkie Farr & Gallagher LLP, states that “financial regulation of advisers to hedge funds and other private funds is expected to increase substantially during 2010.”[64] She goes on to add that “financial reform bills that would require the registration of advisers to hedge funds as investment advisers with the SEC under the Advisers Act appear to have significant momentum behind them.”[65] Of particular interest is a bill that was sponsored by Congressman Paul Kanjorski of Pennsylvania and approved by the U.S. House of Representatives in December, 2009 which would, if enacted, effectively eliminate the private adviser exemption from registration under §203(b)(3) of the Advisers Act.[66] This particular bill is clearly reminiscent of the previously discussed, and unsuccessful, Hedge Fund Rule of 2004 in that it seeks to amend the meaning of “client” under the Advisers Act and forcibly require advisers with 15 or more clients to require with the SEC. In doing so, these changes in regulation would have many effects similar to those proposed within the Hedge Fund Transparency Act as well as those presently in place for funds abiding by §3(c)(1) and §3(c)(7) of the Advisers Act. Such regulatory requirements would include, among other things, extensive record-keeping requirements, disclosure requirements, rules of conduct, subjectivity to examination processes, and standing ready to provide information to the SEC about the adviser themselves and the funds they manage.[67]

VI. THE FUTURE OF HEDGE FUND REGULATION

While it is difficult to say with any real certainty at this time exactly what the future holds for the hedge fund industry, no less trying to predict what future regulations may or may not be enacted, it can certainly be said that many experts and academics alike favor some degree of regulation or another. Long before the term ‘systemic risk’ became everyday vernacular from Wall Street to Main Street, progressive minds felt new regulation would be done. If and when it was done, most would likely agree that future regulation “must reduce the likelihood and potential costs of the failure of systemically important hedge funds whilst at the same time preserving the wider market benefits of hedge funds’ ongoing activities.”[68] It is important that any regulation that is enacted in the years ahead should somehow provide additional transparency, awareness, protection and overall risk management while at the same time allowing hedge fund companies and managers to invest and operate with the degree of anonymity which they deserve and to contribute to overall market efficiency. While some feel that new hedge fund regulations would “create a stable regulatory environment, bring parts of the industry in from the cold, and help lift the veil of secrecy that currently surrounds hedge funds,” others still maintain their rightful concerns.[69]Take for example former US Federal Reserve Board Chairman Alan Greenspan. With his traditionally “laissez-faire” approach to financial markets, he for one might be more inclined to believe that “hedge funds should not be regulated at all because of the efficiency they provide to the financial system.”[70]In a paper he published recently for The Brookings Institute entitled “The Crisis”, Greenspan continues down the “less is more” path, adding that “regulation by its nature imposes restraints on competitive markets. The elusive point of balance between growth and stability has always been a point of contention, especially when it comes to financial regulation.[71] Others, while cognizant of the systemic implications associated with the failure of one or more large hedge funds, agree, too, that the benefits hedge funds provide to the financial system are substantial and that “the trading behavior of hedge funds can improve market efficiency, price discovery and consumer choice.[72] Going even further, and somewhat contrary to what others may say or feel, some believe that “hedge funds may help in alleviating financial crisis.[73]

Others, meanwhile, are taking a much more middle-of-the-road approach, with beliefs that hedge fund regulations can and will help both sides. David Langguth, of EACM Advisors, LLC, a leading investment advisory firm and subsidiary of BNY Mellon Corporation, was quoted in a hedge fund roundtable as saying that “while regulatory initiatives such as increased transparency or registration may affect hedge funds, we do not anticipate measures that will significantly limit most managers’ ability to implement their strategies. Clearly, well designed measures intended to limit potential market abuses generally will be positive for market participants, including hedge funds.”[74]

Looking back again at the failed 2004 Hedge Fund Rule, some feel that “it would be an understatement to say that the Goldstein ruling was a setback for the SEC,”[75] and I cannot say that I disagree. Author Joshua Hess, in a paper entitled “How Arbitrary Really Was the SEC’s Hedge Fund Rule?” argues that the Goldstein decision resulted in a regulatory black hole to which the SEC found itself inadequately able to regulate a financial industry whose continuing growth will have a substantial impact on U.S. financial markets.[76] And, following the series of recent events that have roiled global financial markets, including the outright collapse of Lehman Brothers, the rescue of Merrill Lynch, countless lending institution bankruptcies, and bailout after bailout by central government banks, it feels to many that something, anything, needs to be done. Furthermore, Evan Gilbert, in his paper entitled “Unnecessary Reform: The Fallacies With and Alternatives to SEC Regulation of Hedge Funds” writes that “there appears to be a strong emotional component behind the calls for subjecting hedge funds to SEC registration and disclosure requirements…this fear-based response is understandable, especially in light of the growing number of established institutions either on the brink of collapse, or in some cases actually failing.[77]Once again, something, anything, needs to be done.

Two main ideas that I have come across in my research that stand out as possible solutions include: First, to establish legal limits and/or regulations related to the amount of credit that can be extended to hedge funds by financial institutions. Previously mentioned author Gilbert in his “Unnecessary Reform” paper states, “one of the more straight-forward solutions would be to limit the amount of credit public financial institutions are permitted to extend to hedge funds. Perhaps the most significant concern expressed by those critical of the hedge fund industry is systemic risk…one of the principal causes of systemic failure is failure amongst credit institutions, or more specifically, banks…if banks are limited in the credit they are permitted to extend to hedge funds, any failure of such funds would be less likely to instigate a liquidity crisis.”[78] As previously discussed in the earlier stages of this paper, financial leverage is something specifically available to hedge funds, and a variety of the well-known hedge fund collapses have been attributed to excess amounts of leverage. Therefore, some believe that limiting the amount of credit extended to hedge funds, which is then used to achieve leverage, could help stem systemic risk.

The second recommendation I have come across that I also agree with would be to impose more strict requirements for so-called “accredited investors”. Author David Schneider in his papered titled “If at First You Don’t Succeed: Why the SEC Should Try and Try Again to Regulate Hedge Fund Advisors” argues that the SEC could discourage hedge funds from allowing investors to invest in the hedge fund by changing the definition of an accredited investor.[79] By definition under the Securities Act, an accredited investor is any individual with a net worth that exceeds $1 million or any person with an income in excess of $200,000 in each of the two most recent years. Amazingly, however, Schneider points out an almost unbelievable fact, which is that this net worth/income benchmark has not changed since 1982, and that due to the presence of inflation (rising prices, incomes, etc) and increasing net worth, more and more investors have been satisfying the accredited investor benchmark.[80] It seems to me that it would be worthwhile to adjust the “accredited investor” threshold every year based on inflation rates, so that as incomes and net worth levels continue to rise, more and more individuals do not suddenly qualify as potential hedge fund investors. The income and net worth thresholds should be increased each and every year, so that it remains equally difficult with each passing year for individuals to become qualified as hedge fund investors.

Apart from the aforementioned recommendations, there is one additional point that continues to stand out as something that the government, at least it would appear, should tend to be more concerned with. As I have come to recognize through my research, hedge funds were originally an activity generally for the ultra rich – those with upper-tier income levels, high net worth, and money to spare, and lose. It was the last condition – the fact that they could essentially bare to lose some part of their net worth – that made them suitable hedge fund investors. But yet, over time, so-called institutional investors, such as pension plans, endowments, foundations, schools, hospitals, and so on, have all started to gradually wade further and further into the hedge fund waters. Institutional investors have pensioners and retirees to take care of, and if hedge fund investments go too far and returns go too astray, then those depending on the long-term benefits their retirement assets will provide are the ones who will lose. As such, I believe it is the government’s responsibility and duty to make sure that pension plans and other institutional investors, both public and private, have a strong handle on their investment choices and that they are fully informed as to the possible risks that hedge funds can present.

VII.  CONCLUSION

Hedge funds have enjoyed almost complete anonymity for a number of years, and it has become very evident over the past few years that while hedge funds are not to blame for the various problems our financial system has been dealing with, they certainly do play a very large part. Having more information about them, their actions, their clients, their assets, and so forth, will only help to add a much needed layer of transparency within our fragile financial system. There is also a need to let the financial system be a free flowing system, one that is not encumbered by over-bearing rules and regulations.

 

[1]Houman B. Shadab, The Challenge of Hedge Fund Regulation, Regulation, Vol. 30, No.1, Spring 2007, at 36, 41.

[2] Mark J. P. Anson, CAIA Level I: An Introduction to Core Topics in Alternative Investments 119 (John Wiley & Sons 2009).

[3]Id. at 2. See also James E. McWhinney, A Brief History of the Hedge Fund,http://www.investopedia.com/articles/mutualfund/05/HedgeFundHist.asp.

[4]Financial leverage is essentially the borrowing of capital in order to invest additional assets in a company, hoping that the company’s return is higher than the loan’s interest rate, thus generating excess return on equity. Gabelli, supra, at 2. See also, The Layman’s Finance crisis Glossary,http://news.bbc.co.uk/2/hi/uk_news/magazine/7620678.stm(last updated Sept. 19, 2008).

[5]After reading about short selling and put in rather simple words, short selling is the act of borrowing assets (such as securities) from a third party after which point they are sold in the hope that the value of the assets will go down before repurchasing them again after which point they are then returned to the third party, thus making a profit on the price difference. Securities and Exchange Commission, http://www.sec.gov/news/press/2008/2008-235.htm(last visited Oct. 1, 2008) (Statements of the SEC regarding short selling and issuer stock repurchases. The SEC was explaining the implication of short selling in the light of the current financial crisis and actions taken to control operation).

[6]Implications of the Growth of Hedge Funds, Sep. 2003,http://www.sec.gov/news/studies/hedgefunds0903.pdf.

[7]Id. at 11.

[8]Slutz, supra, at 179.

[9]Craig T. Callahan, Hedge Funds vs. Mutual Funds (2009), http://www.iconadvisers.com/WebContent/Public/PDFDocuments/Hedge_vs_Mutual_Funds.pdf.

[10]Id. at 2.

[11]EurekaHedge.com, http://www.eurekahedge.com/database/faq.asp(last visited Apr. 5, 2010).

[12]WSJ.com, http://guides.wsj.com/personal-finance/investing/how-to-buy-a-mutual-fund/ (last visited Apr. 6, 2010).

[13]Id.

[14]Alistair Barr, How to Buy…Hedge Funds, Sept.11, 2007,http://www.marketwatch.com/story/how-to-buy-hedge-funds.

[15]Mark J. Astarita, Introduction to Private Placements,http://www.seclaw.com/docs/pplace.htm(last visited Apr. 6, 2010).

[16]Lee McGowan, What is a Mutual Fund Expense Ratio?,http://mutualfunds.about.com/od/mutualfundglossary/g/expense_ratio.htm(last visited Apr. 6, 2010).

[17]Id.

[18]Investopedia.com,http://www.investopedia.com/university/mutualfunds/mutualfunds2.asp(last visited Apr. 6, 2010).

[19]Mark Hulbert, 2+ 20, and Other Hedge Fund Math, Mar. 4, 2007,http://www.nytimes.com/2007/03/04/business/yourmoney/04stra.html?_r=1.

[20]Id.

[21]Sec.State.MA.Us, http://www.sec.state.ma.us/sct/sctprs/prsamf/amfidx.htm(last visited Apr. 6, 2010).

[22]Sec.gov, http://www.sec.gov/investor/pubs/inwsmf.htm(last visited Apr. 6, 2010).

[23]Ben McClure, Taking a Look Behind Hedge Funds,http://www.investopedia.com/articles/02/111302.asp(last visited Apr. 19, 2010).

[24]Investorwords.com, http://www.investorwords.com/2837/liquidity.html(last visited Apr. 19, 2010).

[25]Callahan, supra, at 2.

[26]Maintlandgroup.com, http://www.maitlandgroup.com/default.aspx?pid=53(last visited Apr. 19, 2010).

[27]Lock-up period is basically the time period that you must hold your assets (“lock-up” your money) within a fund before they can be removed. What is a Lock-Up Period?, http://www.eurekahedge.com/database/faq.asp#16(last visited Apr. 19, 2010).

[28]Callahan, supra, at 2.

[29]Richard Loth, Mutual Fund Categories,http://www.investopedia.com/university/quality-mutual-fund/chp3-invest-obj/mf-categories.asp(last visited Apr. 19, 2010).

[30]Slutz, supra, at 194.

[31]Morningstar.com,http://corporate.morningstar.com/US/documents/MethodologyDocuments/MethodologyPapers/MorningstarHedgeFundCategories_Methodology.pdf(last visited Apr. 19, 2010).

[32]Vikrant Singh Negi, Legal Framework for Hedge Fund Regulation,http://www.hedgefund-index.com/Legal%20Framework%20for%20Hedge%20Fund%20Regulation.pdf(last visited Apr. 19, 2010).

[33]Tamar Frankel, Private Investment Funds: Hedge Funds’ Regulation by Size, 39 Rutgers L.J., 657, 661 (2008).

[34]Negi, supra, at 3.

[35]David Schneider, If at First You Don’t Succeed: Why the SEC Should Try and Try Again to Regulate Hedge Fund Advisers, 9 J. Bus. & Sec. L. 261, 276 (2009).

[36]Id. at 273-274.

[37]Id.

[38]Negi, supra, at 5.

[39]Schneider, supra, at 277-278.

[40]Thierry Olivier Desmet, Understanding Hedge Fund Adviser Regulation, 4 Hastings Bus. L.J. 1, 15 (2008).

[41]Id.

[42]Id. at 8.

[43]Justin Asbury Dillmore, Leap Before You Look: The SEC’s Approach to Hedge Fund Regulation, 32 Ohio N.U. L.Rev. 169, 177 (2006).

[44]Desmet, supra, at 9.

[45]Id.

[46]Id.

[47]Id. at 10.

[48]Schneider, supra, at 280.

[49]Id.

[50]Janie Casello Bouges, Why the SEC’s First Attempt at Hedge Fund  Adviser Registration Failed, J. of Alternative Investments, Vol. 9, No.3, 89 (2006).

[51]Schneider, supra, at 280.

[52]Id. at 281.

[53]Franklin R. Edwards, New Proposals to Regulate Hedge Funds: SEC Rule 203(b)(3)-2, http://www0.gsb.columbia.edu/faculty/fedwards/papers/New%20Prop%20to%20Reg%20Hedge%20Funds%2001.pdf(last visited Apr. 27, 2010).

[54]Dillmore, supra, at 182.

[55]Desmet, supra, at 22.

[56]Schneider, supra, at 281.

[57]Id.

[58]Desmet, supra, at 22.

[59]Id.

[60]Evan M. Gilbert, Unnecessary Reform: The fallacies with and Alternatives to SEC Regulation of Hedge Funds, 2 J. Bus. Entrepreneurship & L. 319, 328 (2009).

[61]Proposed Hedge Fund and Private Equity Fund Regulation,http://www.orrick.com/fileupload/1633.pdf(last visited Apr. 27, 2010).

[62]Id.

[63]Anita K. Krug, The Hedge Fund Transparency Act of 2009,http://www.law.berkeley.edu/files/Hedge_Fund_Transparency_Act_Comments_A.Krug.pdf(last visited Apr. 27, 2010).

[64]Elizabeth P. Gray, Heightened Government Prosecution and Anticipated Regulation of Private Hedge Funds, 2010 WL 894714 (aspatore).

[65]Id. at 2.

[66]Id.

[67]Id.

[68]Ashley Taylor, et al., Highwaymen or Heroes: Should Hedge Funds be Regulated? A Survey, http://www.ashleytaylor.org/hf_jfs2005.pdf(last visited May 13, 2010).

[69] The Future of Hedge Fund Regulation: Q & A with Ezra Zask and Gaurav Jetley of Analysis Group,http://www.analysisgroup.com/uploadedFiles/News_and_Events/News/AnalysisGroup_Release_Zask_Jetley_HedgeFunds_2009-07-16.pdf((last visited May 13, 2010).

[70]Taylor, supra, at 7.

[71] Alan Greenspan, The Crisis,http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf(last visited May 13, 2010).

[72]Taylor, supra, at 2.

[73] Id.at 3.

[74]Hedge Fund Roundtable,https://privatewealth.mellon.com/en_US/public_content/Resources/documents/CIONewsHedgeFundArticle.pdf(last visited May 13, 2010).

[75]Joshua Hess, How Arbitrary really was the SEC’s “Hedge Fund Rule”? The Future of Hedge Fund Regulation in Light of Goldstein, Amaranth Advisors, and Beyond, 110 W. Va. L. Rev. 913, 940 (2008).

[76] Id.

[77] Gilbert, supra, at  343.

[78]Id. at 345.

[79] Schneider, supra, at 308.

[80]Id.

© 2010 Karol C. Sierra-Yanez

ABA Investment Management Basics Boston Univ. Oct. 13 – 15

The National Law Review is proud to support – the American Bar Association Business Law Section, the ABA Center for Continuing Legal Education, and the Morin Center for Banking and Financial Law of Boston University School of Law present the 3rd presentation of a two-and-one-half day introduction to the regulation of investment companies (mutual funds) and functionally similar entities.

Attend This Program And Learn What You Need To Know About …
  • The structure of the investment management industry
  • The anatomy of an investment company “family” of funds
  • The regulatory scheme imposed on investment companies and related service providers
  • The mechanics of the two “40 Acts: Investment Company Act and Investment Advisors Act”
  • Modern governance standards for investment companies
  • Distribution of fund shares and the fiduciary and regulatory issues raised
  • Contrasting regulation of hedge funds and private equity funds
  • “Hot issues” in the industry

Who Should Attend This National Institute?

  • Lawyers at all levels of experience (including regulators) who are involved or expect to become involved in issues surrounding the investment company industry
  • Private practitioners who advise corporate clients on related matters
  • Consultants, accountants, and bank executives seeking a more comprehensive understanding of this changing industry

MCLE

Mandatory continuing legal education (MCLE) accreditation has been requested from all states that require continuing legal education. 17.50 hours of CLE credit, including 1.00 hours of Ethics credit, have been requested from those states recognizing a 60-minute credit hour and 21.00 hours of CLE credit, including 1.00 hours of Ethics credit, have been requested from those states recognizing a 50-minute credit hour. For NY-licensed attorneys: This transitional CLE program has been approved for all NY-licensed attorneys in accordance with the requirements of the New York State CLE Board (17.50 including 1.00 

hours of Ethics total NY transitional MCLE credits).

For more information and to register go to the ABA CLE Website.


ABA – The Fifth Annual National Institute on Securities Fraud Oct 7 & 8th New Orleans

Looking for a good excuse to head to New Orleans?  The National Law Review would like to remind you that the American Bar Association’s Business Law Section, Criminal Justice Section, Section of Litigation, and the Center for Continuing Legal Education are sponsoring the 5th Annual National Institute on Securities Fraud: 

The aftermath of the global financial crisis continues to cause uncertainty in the areas of securities regulation and enforcement. SEC and DOJ collaboration has increased, with both agencies pursuing aggressive legal theories.  Congress has passed the most sweeping changes to the federal securities laws since they were enacted in the 1930s. And state attorney generals continue to assert a significant role in enforcing state securities laws.

This unprecedented confluence of events raises significant questions for industry participants and publicly traded companies that require a forward-looking and flexible approach to avoiding missteps.

The 2010 program will squarely address the issues and trends that are shaping the direction of securities regulation and enforcement for decades to come, including the status and potential impact of financial reform legislation,  the enforcement trends suggested by recent cases, and the priorities of top enforcers.  The program will provide valuable strategic and tactical insights to navigate this ever-changing terrain, from the perspective of thought leaders of every persuasion, including judges, prosecutors, regulators, compliance officers, and defense counsel.

The Securities Fraud National Institute Planning Committee, in cooperation with the Criminal Justice Section White Collar Crime Committee and the Business Law Section, will provide an educational and professional forum to discuss the legal and ethical issues that arise in securities fraud matters. For More Information – Click Here: