The regulatory tide continues to roll a year after President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act. This past week, the SEC and CFTC jointly adopted a rule that will require many hedge fund advisers to complete a new form that discloses detailed information about their funds’ holdings and investments to federal regulators.
Federal regulators intend to use this information to monitor the risks that large hedge funds, liquidity funds and private equity funds may pose to the nation’s overall financial system.
The rule requires SEC-registered investment advisers and dually registered CFTC registrants with at least US$150 million in managed private fund assets to file periodically a new reporting form, Form PF.i The level of detail that fund advisers must disclose depends on the size of their funds.
Under the rule, the data that advisers disclose on Form PF will not be made publicly available; instead, the information will only be provided to federal regulators, including the SEC, CFTC, and Financial Stability Oversight Council (a Dodd-Frank creation). Regulators may, however, aggregate and publish certain generalized data on the size and scope of the hedge fund industry without identifying individual funds or advisers.
The following are the rule’s key provisions that apply to hedge fund advisers:
Requirements for hedge fund advisers with managed assets between US$150 million and US$1.5 billion
File Form PF within 120 days of the end of each fiscal year
Report general fund strategy, size, leverage and performance
Disclose the percentage of the fund’s equity held by the five largest equity holders
Provide the approximate percentage of each fund beneficially owned by certain types of investors
List what firms are handling the fund’s trading and clearing operations
Report counterparty risk
Requirements for hedge fund advisers with more than US$1.5 billion in managed assets
File Form PF within 60 days of the end of each fiscal quarter
Disclose the information summarized above
Report on an aggregated basis detailed information regarding exposure by asset class, geographical concentration, and turnover by asset class
Any hedge fund with a net asset value of at least US$500 million must provide detailed information including the fund’s portfolio liquidity, holdings of unencumbered cash, concentration of positions and collateral practices with counterparties
Significantly, no hedge fund adviser, regardless of fund size, will need to disclose position-specific information. The CFTC and SEC initially proposed requiring advisers to disclose such information, but backtracked in response to concerns raised by the hedge fund community.
Hedge fund advisers must commence filing their Form PFs in connection with their funds’ first fiscal year or fiscal quarter that ends on or after December 15, 2012. For funds with total assets valued at more than $5 billion, this deadline is advanced to June 15, 2012.
Risks posed by the new rule
1. Exposure to increased enforcement activity
The vastly increased transparency required by the rule opens the door to more robust enforcement activity by hedge fund regulators. The highly detailed disclosures for large hedge funds create potential exposure for failure to comply with the rule. The Form PF disclosures could also encourage the SEC and other regulators to explore previously unconsidered areas of inquiry and facilitate their investigations into hedge fund activities.
2. Determining whether an adviser’s hedge funds will trigger the reporting thresholds
The rule requires monthly testing by every hedge fund adviser to determine whether the adviser’s funds trigger the US$1.5 billion threshold for quarterly reporting. If the threshold is satisfied in any given month, then the adviser must file the quarterly report on Form PF. This monthly testing not only adds another administrative burden on hedge fund advisers, but also increases compliance risk for advisers that fail to conduct monthly tests or accurately calculate total fund assets as specified in the rule.
3. Although certification is not subject to penalty of perjury, accurate information must still be disclosed
The SEC and CFTC initially proposed that advisers affirm each Form PF “under penalty of perjury” that the statements contained therein are “true and correct.” This requirement was eliminated in response to numerous objections. Under the approved version of the rule, advisers will be required to sign the Form PF and confirm that it was filed with proper authority. Despite the elimination of the perjury certification, hedge fund advisers should still take care not to misrepresent any facts or data when completing the Form PF to minimize potential enforcement liability.
4. Roadmap for discovery in civil cases
Although the rule claims that the information disclosed by hedge fund advisers on the new Form PF will be kept confidential, it does not contain any protections against discovery of the form in civil litigation. As a result, it is likely that the disclosures will quickly become the target of discovery requests or subpoenas directed to the hedge fund adviser, the SEC or the CFTC. Litigants as well as hedge fund competitors or traders may also attempt to secure copies of the Form PFs through FOIA requests.
These discovery tactics are especially problematic for large hedge funds that are required under the rule to report the most detailed level of information. Given the commercial sensitivity of the information disclosed on their Form PFs, hedge fund advisers should only produce the forms in civil discovery after the entry of an appropriate protective order. While not perfect, this measure will reduce the risk that the fund adviser’s competitors will acquire the forms and use the information contained therein to their advantage.
For more information about the rule’s disclosure requirements, potential risks and heightened regulatory scrutiny, please contact Perrie Weiner, Nicolas Morgan or Andrew Escobar.
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i The SEC is adopting the rule as Rule 204(b)-1 [17 CFR 275.204(b)-1] and Form PF [17 CFR 279.9] under the Investment Advisers Act of 1940. The CFTC is adopting the rule as Rule 4.27 [17 CFR 4.27] under the Commodity Exchange Act and Form PF.