SEC to Hedge funds: No need to use “plain English”

Hedge Fund Regulation 17 Aug 2010

Who can forget the SEC’s 2005 attempt to force hedge funds to register themselves as investment advisers?  Regulatory antagonist and hedge fund manager Phil Goldstein’s challenge of the SEC’s “hedge fund rule” eventually led to it being vacated by the courts.  Nonetheless, around half of US hedge funds remain SEC registered to this day (mainly because of the marketing imprimatur that accompanies such registration).

SEC-registered hedge funds may want to take note of another recent SEC ruling – this one pertaining to what the Commission calls the “brochure”, a questionnaire containing details on the investment adviser that is required to be hand to clients before they invest with the adviser.  It appears the typical brochure is a little cryptic for clients to understand.  In an effort to improve transparency, the SEC recently ruled that it must adhere to the Commission’s “Plain English Handbook“.  This bulletin from law firm  Akin Gump Strauss Hauer & Feld LLP describes the change in, well, plain English. (Hat tip: Opalesque).

As the SEC writes in its “Plain English Handbook“,

“While your audience will include analysts and other industry experts, you may want to keep in mind that your least sophisticated investors have the greatest need for a disclosure document they can understand.”

The SEC’s amendment (downloadable here) comes into effect on October 12, 2010.  But before hedge funds go out and hire a professional editor to translate their brochures from legalese to plain English, they will want to take note of the following…

Goldstein’s court challenge of the SEC’s hedge fund rule was predicated on the definition of “client.”  The courts ultimately agreed with him that a hedge fund manager owed their fiduciary responsibility to the hedge fund itself, not to the end investors in hat fund.   As a result, the fund qualified as only “one” client, not many.  This meant that most hedge fund managers had only a few clients and were therefore exempt from registration.  (read the ruling itself)

Although pending legislation promises to close this loophole, it means that currently, hedge funds still don’t have to treat end investors as clients.  Since the SEC’s brochure is meant for “clients” only, this means that hedge fund managers need to provide this information only to the hedge fund itself.

So who will be the audience for these plain English prose? As the SEC’s recent ruling says in a footnote (#192):

“Two commenters urged us to adopt an exception for “hedge funds,” or clarify that advisers to hedge funds are not required to deliver copies of brochures to their investors…We note that rule 204-3 requires only that brochures be delivered to “clients.” We further note that the Court of Appeals for the D.C. Circuit stated that the “client” of an investment adviser managing a hedge fund is the fund itself, not an investor in the fund.”

If your “least sophisticated investor” is a hedge fund, your version of plain English will probably not be the same as that of, say, USA Today.

But as advocates of plain English, we urge hedge funds to read the SEC’s tutorial on the topic.  After all, writes Akin Gump Strauss Hauer & Feld,

“…fund advisers are not required to deliver the Brochure to prospective fund investors. We note, however, that as a matter of practice, many fund advisers choose to do so.”

By allowing end investor communication to be voluntary, the hedge fund manager is free to continue to use the unclear, jargon-laden prose that is synonymous with hedge fund investing.

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