Thursday, February 11, 2010

House Bill May Impose Prudential Standards on Investment Funds

On December 11, 2009, the House of Representatives passed bill H.R. 4173, the Wall Street Reform and Consumer Protection Act (the “Bill”), which sets forth, among other things, systemic regulation provisions that could significantly affect the private funds industry. The Bill was referred to the Senate on January 20, 2010, and is currently being considered by the Senate’s Committee on Banking, Housing and Urban Affairs.

Apart from the incorporation of the Private Fund Investment Adviser Registration Act introduced in October 2009 as H.R. 3818, the most notable aspects of the Bill for investment funds are the “prudential safeguards” imposed on any firm that is deemed to engage, directly or indirectly, in “financial activities” (a term which is not defined in the Bill) where regulators determine that either (i) financial distress suffered by the firm could present a threat to financial stability or the economy, or (ii) the nature, scope, size, scale, concentration, interconnectedness or mix of the firm’s activities could present such a threat. The generalized wording of the Bill strongly suggests that investment funds, including private equity and hedge funds, could be subject to the bank-like prudential safeguards introduced by the Bill, which could impose the following consequences:

  • capital requirements and liquidity standards (thereby in effect limiting permissible leverage);
  • a cap on investments in voting securities of non-financial companies (capped at 5% of any class of such securities);
  • a 15-to-1 debt-to-equity ratio;
  • limits of short-term borrowings and other bridge financings;
  • restrictions on concentrations of counter-party credit exposure; and
  • quarterly stress testing requirements.
Given the intent of the Bill sponsors to limit systemic risks posed by certain major firms, it is expected that the risk to small funds of being subject to the Bill's prudential standards is limited, as it is unlikely that regulators would deem them to present a systemic risk to the economy. However, the Bill does not preclude such regulation, and the risk of being covered by this prudential regulation and its attendant burdens is particularly acute in the case of funds with large amounts of assets under management and/or highly leveraged investment strategies. Finally, since the Bill does not restrict the definition of a "financial company" subject to its prudential safeguards only to domestic firms, even non-U.S. funds may be covered so long as they have significant operations in the United States through a U.S. affiliate or U.S. operating entity.