By implementing this aspect of the Dodd Frank Wall Street Reform and Consumer Protection Act 2010, the US is the first to deliver legislation that has a far reaching impact affecting investment managers globally. In contrast, Europe’s own Alternative Investment Management Directive (AIFMD) is not expected to be implemented until 2013.
Who is covered by this requirement?
If there are 15 or more U.S. investors in private funds advised or managed by the firm, or the firm advises or manages more than £25m assets attributable to U.S. investors, the SEC is likely to want to hear from it. If less than $150m of private fund assets are managed from a location in the US, and this will apply to many non-US managers, the firm may be eligible for Exempt Reporting Adviser (ERA) status. So how will rules passed in Washington affect fund managers in London ? or indeed any manager responsible for the assets of U.S. investors?
What the SEC proposes for those caught by Dodd Frank
There is an annual reporting minimum for funds subject to ERA, though the SEC will also require books and recordkeeping requirements, pay to play rules for political contributions and lobbying and the right to inspect non-US managers. Full registration means complying with the SEC’s rules and regulations ? code of ethics, personal account trading, marketing disclosures ? that may be stricter, or more prescriptive than existing compliance obligations.
While the UK Financial Services Authority (FSA) has developed its own hedge fund survey to help understand the impact of the alternative sector, the SEC’s data collection is broader than previously required, particularly with the level of fund data required within their amended ADV Part 1 registration form, which seeks to obtain private fund data to help the SEC analyse the sectors role in the overall systemic risk of the economy and an individual manager’s potential conflicts of interest.
Other additive requirements are the extension of U.S. anti-fraud provisions and pay to play rules governing the relationship between the firm and prospective government investors, particularly state pension funds. These address a very specific area of current sensitivity in the US, otherwise addressed in the UK by conflicts of interest and inducements rules.
Rule 204-2 of the Investment Advisers Act defines the books and record keeping requirements of a SEC registered adviser. Although the SEC has not defined the types of books and records an ERA should maintain, we expect these will need to meet this baseline for documentation standards, nothing of which should cause an FSA-regulated investment manager sleepless nights.
The requirements for a fully registered firm are more extensive; firms are expected to maintain a compliance programme, appoint a chief compliance officer and undertake an annual compliance review. There are equivalent requirements under FSA rules and firms would do well to exploit potential synergies in their compliance oversight.
SEC-registered firms are also required to have a code of ethics. This is usually a separate document containing policies and procedures for complying with U.S. securities laws and rules pertaining to standards of business conduct and fiduciary duties (in the UK this is broadly covered by FSA principles and SYSC), confidentiality (data security and confidentiality), personal account dealing, conflicts of interest management, internal violations (breach) reporting and written employee undertakings of compliance.
SEC-registered firms must have policies and procedures to combat the risk of insider dealing. More restrictive requirements apply to client solicitations than to financial promotions in the UK, particularly performance disclosure and contractual requirements over the use of placement agents, though these are not inconsistent with good practice. Proxy voting rules give greater formality over an existing conflict that UK managers face today and currently address through conflicts of interest procedures and stewardship responsibilities.
Many UK managers will not be affected by SEC custody rules, save for confirming that they have no authority over the withdrawal of funds from customers’ accounts and for ensuring the fund is audited and its financial statements, which have been prepared in accordance with generally accepted accounting principles, are distributed to investors within 120 days of the funds’ year end.
A special relationship
The challenge for UK-based fund managers is to determine how far the SEC’s prescriptive rule-based regime can co-exist with the FSA principles based framework.
Despite the different registration requirements, the approach to alternative asset management regulation is standardising. Regulators share concerns over systemic risk, over the unknown impact of shadow banking and, increasingly, the FSA sees enforcement, fines and suspensions as effective tools to be used more widely. The language of regulation, though, still accentuates the differences; codes of ethics, pay to play, proxy voting, client solicitation are unfamiliar terms in a UK compliance culture steeped in principles, market abuse controls, conflicts of interest management and financial promotions.
With two regulators to contend with, firms may choose simply to create an illusion of compliance through re-papering their policies and procedures using off the shelf SEC compliance documentation. However, like the FSA, the SEC expects a registered adviser to tailor its compliance documentation to its own business. An approach that layers SEC rules on top of FSA ones is likely to lack credibility from both regulators, while alienating staff required to read, and sign acceptance to, duplicate procedures.
That said, the SEC is pragmatic and it understands firms are subject to different rules. SEC inspections should take account of the local regulatory environment and how existing arrangements are adapted and enhanced to meet the SEC. Firms will need to understand the similarities as well as the differences to respond.
Understanding the extent to which the FSA and SEC have similar objectives and requirements, despite different terminology, is key to designing proportionate and pragmatic updates to firms’ compliance infrastructures. Global regulators interests are, however, largely aligned. The FSA and SEC’s rules cover similar ground ? governance and compliance programmes, conflicts of interests, investment execution and commission sharing, business continuity and data security. If caught by the SEC’s scope, firms should consider how they integrate the SEC requirements into existing compliance arrangements rather than introducing standardised and un-tailored compliance documentation.
This creates an opportunity for many firms. Faced with continuing regulatory uncertainty in the UK and across Europe and the extension of the SEC’s ambit, firms are looking to the highest common denominator of the different regimes to stay ahead of the regulators and politicians. For many firms, it will not be cost-effective, practical or logical to run dual compliance regimes, reflective of which authority cares to call. It will become incumbent upon them to define arrangements that meet their interpretation of global regulation. A common regulatory framework could be developing for alternative fund managers ? not one shaped by politicians or by European regulatory integration ? but by the U.S.’s insistence that it must have oversight of funds.
By: Brendan Wilde