Although the Dodd–Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”) was passed over five years ago, regulators are still untangling the myriad of financial reforms mandated under this law. Shortly after the passage of the Dodd-Frank Act Congress passed the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), which then loosened many of the restrictions that historically applied to public companies. These laws made extensive reforms related to enhancing investor protection, mitigating systemic risk, and promoting capital formation. Given these sweeping changes, academics across disciplines have undertaken the arduous task of investigating the theoretical and empirical impacts that these reforms have had on various market participants. Scholars have taken a particular interest in examining the eroding distinction between public and private entities in light of these seismic shifts in our securities law framework. They have mostly focused on the incoherent treatment of “publicness” under both the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”).
Even still, academics have focused minimal attention on how the concept of publicness has recently transformed within the investment fund industry, which is subject to intricate layers of regulation that extend beyond the Securities and Exchange Acts. This analysis deserves heightened attention since investment funds collectively manage over $18 trillion for over 90 million households in the United States. Moreover, the Dodd-Frank Act has seemingly muddled the distinction between public and private investment funds through its haphazard regulation of hedge funds and other private funds. While Congress largely designed this legislation to mitigate systemic risk, it has seemingly complicated the intricate patchwork of regulation that currently applies to these entities. With this increase in regulatory complexity, unique investor protection concerns have likely arisen for fund investors. These concerns, which are further discussed below, relate to the possible over-inclusive and under-inclusive indicators of publicness that are now embedded in this elaborate web of legislation.
As background, investment funds, such as mutual funds and money-market funds are considered “public” entities given their extensive registration requirements (“Registered Funds”). Although the term “public” has not been specifically defined under the federal securities laws, Registered Funds are subject to multiple layers of legislation because they are available for investment by the public at large. Such investors are generally referred to as retail investors and they are automatically guaranteed various investor protection mechanisms provided under these laws. Registered Funds must therefore register under the Investment Company Act of 1940 (“1940 Act”), which is the primary legislation that is tailored to the industry. It includes detailed disclosure mandates, restrictions on riskier investments and strategies, governance requirements, and several other directives that extend beyond the “truth in securities” framework under the inaugural Securities and Exchange Acts.
Registered Funds must still register under a number of ancillary laws, which includes both the Securities and Exchange Acts. If a Registered Fund is engaged in the trading of futures or other derivatives, then it could be subject to additional regulation under the Commodity Exchange Act of 1936 (“Commodity Exchange Act”), unless there is an available exemption. The advisers of Registered Funds must also register under the Investment Advisers Act of 1940 (“Advisers Act”), which triggers heightened fiduciary duties for such advisers to act in the best interest of their clients. Registered advisers must also disclose material information relating to their business practices, fees, disciplinary history, certain conflicts of interest, and other material information related to their advisory business.
In contrast, private investment funds, which include hedge funds, and private equity funds, are generally exempt from the complex web of regulation applicable to Registered Funds (“Private Funds”). Private Funds evade regulation by restricting investors to institutional investors and high net-worth individuals. Such investors are deemed to have the resources to adequately protect themselves without the need for federal safeguards. In exchange for restricting investors in this manner, Private Funds have more flexibility to incur leverage and pursue innovative strategies, which can incorporate derivatives, illiquid instruments, and other unique financial instruments. They are also exempt from the detailed disclosure and governance requirements intrinsic in these laws. Private Fund industries have grown exponentially in recent decades since institutional investors such as pension plans, insurance companies, and endowments are increasingly relying on these vehicles to manage risk and earn returns. Some estimates have found that hedge funds manage over $3 trillion in the United States, with private equity funds managing over $1 trillion in assets under management.
While Private Funds have historically evaded significant regulation, they were beholden to the requirements embedded in the intricate web of exemptions provided under the laws enumerated above. These requirements can be referred to as “indicators of publicness” since they effectively serve as bright-line dividing lines between public and private funds. A prevalent indicator of publicness includes the status of investors since investment funds that restrict offerings to elite investors are considered private and are thus exempt from federal regulation. An additional indicator includes advertising, where investment companies that broadly solicit investments from the general public, such as mutual funds and money-market funds, are required to register under the federal securities laws. This particular indicator of publicness was drastically altered under the JOBS Act as Private Funds can now advertise without triggering the registration requirements under the Securities Act. Additional indicators include size of the pool, and number of investors/clients. Under the Exchange Act for example, Private Funds that have over $10 million in total assets avoid registration by restricting ownership to less than 2,000 persons (after the passage of the JOBS Act), or less than 500 persons who are unaccredited investors.
However, evolving “notions of publicness” started to emerge within the investment fund industry that were not easily captured by the existing securities law framework. Regulators grew primarily concerned that the innovative financial products and strategies utilized by Private Funds could adversely affect the general public by increasing and transmitting systemic risk. The near failure of Long-Term Capital Management (“LTCM”) in 1998 catapulted Private Funds into this emerging debate. LTCM’s leverage was so exceedingly high, that it was set to default on over $1 trillion in debt to a number of investment banks. The default of these obligations would have likely crippled the global economy, which prompted the Federal Reserve to orchestrate a private deal amongst LTCM’s counterparties.
Additional concerns expressed by Congressional and SEC reports include the participation of Private Funds in the shadow banking industry and the retailization of Private Funds. With respect to shadow banking, Private Funds were arguably engaged in the creation and distribution of credit through their trading of certain derivative instruments. This led to an opaque market that seemingly increased leverage in the broader financial markets while escaping regulation by banking regulators. With respect to retailization, retail investors are often indirectly exposed to Private Funds through their pension plan investments. Since pension plans qualify as institutional investors that can sufficiently protect themselves, they are not guaranteed the investor protection measures mandated under federal securities laws. As pension plans started to expand investments into Private Funds to earn returns and manage risk, regulators queried whether underlying retail investors were sufficiently protected.
Congress finally responded to these evolving notions of publicness with the passage of the Dodd-Frank Act. This legislation created new registration requirements under ancillary legislation such as the Advisers Act and Commodity Exchange Act, as opposed to focusing on the 1940 Act, which is the primary legislation that governs the industry. In summary, many Private Fund advisers must now register under the Advisers Act, which is often viewed as being the least restrictive amongst the federal securities laws. It includes additional fiduciary obligations and disclosure information for registered advisers, but does not restrict leverage, require standardized valuations, or mandate many of the other investor protection mechanisms provided under the 1940 Act. The Dodd-Frank Act did amend the Advisers Act to require that Private Fund advisers provide additional proprietary information to the SEC, which is supposed to remain confidential. The SEC can however disclose this information to the newly created Financial Stability Oversight Council (“FSOC”). This entity is broadly charged with regulating entities that pose a systemic threat to the economy. In terms of increased regulation under the Commodity Exchange Act, many OTC derivatives, which are frequently traded by Private Funds, must now be traded through registered clearinghouses. Under authority granted under the Dodd-Frank Act, the CFTC also retooled many exemptions to make it more difficult for Private Funds to avoid regulation under the Commodity Exchange Act.
By and large, since these evolving notions of publicness have been integrated into ancillary laws, or addressed through additional layers of regulation, Congress has effectively expanded and complicated the patchwork of regulation that applies to these entities. The extent to which this increase in regulatory complexity will protect the general public is also questionable. FSOC has yet to identify a Private Fund as being systemically harmful as the council has been embroiled in battles with the industry over appropriate measures of systemic risk. In the meantime, the SEC still collects such confidential information from Private Funds in an incoherent and inconsistent manner. Mandating registration under the Advisers Act could enhance investor protection to a degree, but such investor protection mechanisms are minimal in relation to the 1940 Act. Enhancements under the Commodity Exchange Act could also boost transparency with respect to various OTC derivatives, but many scholars have argued that these new reforms can serve to concentrate systemic risk amongst these newly authorized central clearinghouses.
In fact, Congress’s avoidance of the 1940 Act could harm investors as this primary legislation still relies on historical indicators of publicness, such as status of investors for example, in delineating private and public investment funds. Since these historical indicators do not appropriately reflect the emerging notions of publicness discussed herein, they are likely under-inclusive and over-inclusive from an investor protection standpoint. In terms of such indicators being under-inclusive, a systemically harmful Private Fund could still evade regulation under the 1940 Act. Retail investors could thus be exposed, albeit indirectly, to systemically harmful funds that evade significant regulation. For instance, the Texas County & District Retirement System has recently allocated 25 percent of its assets into Private Fund investments. If this pension inadvertently invests with a hedge fund that is later deemed systemically harmful, while FSOC is engaged in the opaque and unpredictable process of analyzing this same fund, the retirement accounts of its thousands of underlying retail investors could be compromised.
These historical indicators of publicness can also be over-inclusive as they prevent regulators from distinguishing amongst the heterogeneous strategies of Private Funds. Contrary to popular belief, many of these strategies do not pose a systemic threat to the economy. Since regulators have not looked behind the status of investors in determining the publicness of investment funds, they have not made these nuanced distinctions. This leaves retail investors with limited options in terms of maximizing returns and managing risk. Mutual funds, which form a major component of 401(k) retirement accounts for retail investors across the country, are automatically subject to the stringent capital restrictions under the 1940 Act. They are therefore limited in the innovative strategies that they can pursue given the restrictions on derivatives, illiquid instruments, distressed securities, and other exotic instruments. These limitations become more problematic during economic downturns when Private Funds have more freedoms to engage in short-selling and other tactics to help investors earn absolute returns irrespective of market conditions.
To better protect investors in these constantly evolving markets, Congress should redirect its attention to the 1940 Act. With this constant focus on ancillary legislation, there is a lack of clarity as to the distinction between public and private funds. Making this distinction is now a convoluted task that involves an analysis of several ancillary exemptions, and attempting to predict the circumstances under which FSOC may deem a Private Fund systemically harmful. Congress can achieve this ambitious goal by first directing regulators to agree on appropriate levels of systemic risk indicators, such as leverage, interconnectedness, substitutability, complexity, and/or global activities. Once these indicators have been agreed upon, regulators can then integrate these indicators into existing 1940 Act exemptions. A basic example related to interconnectedness could read as follows (with x being the agreed upon indicator): “Private Funds relying on section 3(c)(7), shall have a ratio of collateral posted relative to its NAV that does not exceed x percent.” Thus, Private Funds that are excessively interconnected with other financial institutions would be forced to register under the 1940 Act.
Any such amendments would then require a wholesale review of the 1940 Act as many of its restrictions may unduly affect capital formation for newly registered entities. The existing restrictions on leverage and derivatives would likely need retooling to accommodate a larger range of innovative strategies that are currently utilized by Private Funds. Updating these capital restrictions would also create more opportunities for retail investors to directly access strategies that would better protect their investments in declining markets. However, updating these provisions (among others) would be an arduous task as the 1940 Act is widely known as being the most complex and cumbersome legislation within the securities law realm. Dedicating resources to this endeavor may fail to engender political support, which may have played a role in Congress’ decision to avoid the 1940 Act in the new regulation of Private Funds. Nevertheless, revamping the 1940 Act is long overdue and can be delegated to a number of regulatory agencies. This onerous task will likely become a necessity with the endless stream of innovations that will inevitably pervade the industry. By continuing to focus on ancillary legislation to accommodate these changes, the industry’s regulatory patchwork will continue to grow in complexity, leading to a possible increase in investor protection harms.