By Paul Roth
The Dodd-Frank Wall Street Reform and Consumer Protection Act will require hedge fund managers with assets under management of $100 million ($150 million if their only clients are hedge funds) to register under the Investment Advisers Act, but that may be only its most obvious impact. The outcome on a significant number of issues—including manager compensation, short sales, and the way advisers collect and maintain systemic risk data—is subject to rulemaking by the Securities and Exchange Commission. Not until the SEC formulates its rules will we be able to assess the full impact.
One of the potentially most troublesome arenas is in compensation arrangements. Compensation programs that hedge funds arrange with their investors are an essential element of the industry, and these incentive-fee arrangements are transparent.
Yet the act requires that regulators jointly prescribe rules for so-called covered financial institutions, including registered investment advisers, to disclose the structure of their incentive-based compensation arrangements and prohibit those arrangements that encourage inappropriate risk taking or could lead to material financial loss.
Until the Financial Services Authority's July 29 release for comment of its consultation paper, "Revising the Remuneration Code," which may require deferral of 40% to 60% of variable compensation for many employees of the advisers to private funds, I thought these requirements weren't likely to have a significant impact on pay packages. Now, one cannot be too certain!
While I doubt the SEC will follow the FSA's lead, any such changes would have an enormous impact. To work fairly, these changes to compensation programs would need to be reconciled by a modification in the tax rules. Ironically, incentive-fee deferrals were common until Congress eliminated this practice a few years ago. We will be closely monitoring developments at both the SEC and the FSA (which, at a minimum, will be regulating UK affiliates of U.S. managers). The saving grace is that the act appears to exempt advisers with assets on their balance sheet of less than $1 billion from compensation rules.
Other provisions whose potential effects are unclear include a mandate that the SEC adopt rules for the monthly reporting of short sales. It isn't certain who will be required to report nor what information will be required, other than the issuer's name and the security's CUSIP number. Two studies have been mandated to review short sales, including one that will examine the feasibility of indicating on the Consolidated Tape whether trades are short, market-maker short, buys, buys for cover or long. If implemented, such a proposal could put the market on notice of the accumulation and liquidation of short-sale positions on a real-time basis. Would such a reporting regime make short selling more difficult and expensive?
Given Congress' move towards systemic risk regulation, being registered as an investment adviser will now require more recordkeeping and reporting of data. The act mandates that advisors report assets, leverage, counterparty risk exposure, trading and investment positions, valuation policies and practices, types of assets held, side arrangements or side letters, and trading practices. Moreover, this list can be expanded to include anything else the SEC "determines is necessary and appropriate in the public interest or for the assessment of systemic risk." Defining what is required could make the task easier in some ways but more complicated and expensive because systems will have to be designed to capture the required information. Moreover, while the act provides confidentiality for such information provided to the SEC, already there are calls in Congress to make such information public.
Other provisions that will affect hedge fund managers include the Volcker Rule and the resolution authority given to the Federal Deposit Insurance Corporation to liquidate nondepositary financial entities. Also to be closely watched is the impact of the Fed's new authority to determine whether certain hedge funds are systemically relevant and thus must set aside additional capital cushions or reduce leverage and increase liquidity. The regulation and manner of trading derivatives has also been significantly changed.
The full impact of this new regulation of hedge fund managers will not be known until the implementing rules are adopted. They could be far reaching. This is truly a case where the devil will be in the details. AR
Paul Roth is a founding partner at law firm Schulte Roth & Zabel.