Impact of the "Hedge Fund Sunshine Act" on the Hedge Fund Industry, Absolute Return

Examining potential outcomes of the recently proposed legislation.

On November 4, 2015, Representative Nydia M. Velázquez (Democrat­-New York) proposed a bill (H.R. 3921) for a new law (to be known as the “Hedge Fund Sunshine Act of 2015”) that would amend Section 13(d) of the U.S. Securities Exchange Act of 1934 to require additional reporting by hedge funds. According to a statement released by Representative Velázquez, the bill is in response to Puerto Rico’s debt crisis and is intended to “allow regulators and the public to see exactly what role these funds are playing in Puerto Rico’s financial crisis and in our broader economy.” However, the proposed law is not limited to disclosures about a hedge fund’s impact on the Puerto Rican economy and broadly applies to investments irrespective of geographic location.

Generally, under current law, unless an exemption applies, a person that becomes the beneficial owner of more than 5% of a class of registered equity securities must, within ten days after passing that threshold, file a report with the Securities and Exchange Commission (the “SEC”) that details, among other things, information on the beneficial owner, the source of funds used to purchase the securities, the purpose of the acquisition, and other relationships and understandings that the beneficial owner may have with the issuer. The law is intended to provide the public with information about significant shareholders of public companies and the reasons they are acquiring greater than 5% of any class of equity shares, which could include hostile takeovers and other attempts to gain control over a company. The proposed law does not address the availability of Schedule 13G as a reporting form and the implications on its availability in the event of the approval of the proposed law.

The Hedge Fund Sunshine Act of 2015 would instead require a hedge fund to file these reports within five days after becoming a beneficial owner of 1% or more of a class of registered equity securities. In addition, unlike other beneficial owners, a hedge fund would be required to include certain derivative instruments in calculating its beneficial ownership for purposes of determining whether it has a filing obligation. Furthermore, a hedge fund that has $100 million or more in assets under management and that is, directly or indirectly, the beneficial owner of more than 1% of a class of any equity or debt security (including certain derivative instruments for purposes of determining its beneficial ownership) would be required to file, within three days after the end of every quarter, a report with the SEC disclosing that ownership interest. This report would also be publicly available on the SEC’s website.

The Hedge Fund Sunshine Act of 2015 would have a number of important implications for the hedge fund industry, including the following:

• Additional Compliance and Reporting Costs. If enacted, the new law would require hedge funds to file their Section 13(d) reports on a more frequent basis and for smaller positions and would prevent their use of derivatives to stay below the reporting threshold. As a result, hedge funds could expect additional compliance, monitoring, and reporting burdens and costs if this law is enacted.
• Competitive Concerns. Enhanced transparency and more frequent reporting would provide competitors, issuers, and other market participants with far greater and more current insight over the portfolio holdings of each fund, allowing them to potentially exploit such positions and strategies and react to and trade on these disclosures. Moreover, the law singles out hedge funds and other types of institutional investors would not have the same reporting obligations. It would therefore be more difficult and more costly for hedge funds to build aggregated positions in certain securities or to effect particular strategies, including activist strategies.
• Transparency on Debt Securities. Under the proposed law, hedge funds with at least $100 million in assets under management would also be required to disclose on a quarterly basis their ownership interests of more than 1% of any class of any security (including debt securities). Therefore, hedge funds would be obligated to report their debt holdings (including corporate bonds, government debt, municipal bonds, and certain collateralized securities) that exceed this threshold, which are currently not disclosed at all under Section 13(d) of the Exchange Act. This new disclosure requirement is intended to address Representative Velázquez’s concern that hedge funds are using their ownership of government debt to influence the restructuring of that debt without adequate public knowledge.
• Under the proposed law, the definition of hedge fund is drafted broadly enough to also potentially capture other types of private investment funds as well such as private equity funds, venture capital funds, real estate funds, etc.

As of now, the bill is in its initial stages and appears to be unlikely to be approved by a Republican­-controlled Congress. If approved in its current form, the bill would significantly increase the reporting obligations of hedge funds and has the potential to alter ways in which hedge funds conduct business. However, even if this bill is not approved, aspects of this bill could be included in future legislation.

Jedd Wider is the Co­-Head of the Global Hedge Fund Practice at Morgan, Lewis & Bockius LLP and Joseph Zargari is an Investment Management associate at Morgan, Lewis & Bockius LLP. This article does not represent legal advice or the views or opinions of Morgan, Lewis & Bockius LLP.