On June 22, 2011, the United States Securities and Exchange Commission adopted final rules and rule amendments under the Investment Advisers Act to implement certain provisions of the Dodd-Frank Act regarding the registration of investment advisers and managers of private funds. As discussed further below, the final rules (i) extend the deadline for registration with the SEC until March 30, 2012, (ii) clarify some new exemptions from investment adviser registration created by the Dodd-Frank Act, (iii) set forth a uniform method for investment advisers to calculate their assets under management for several regulatory purposes, (iv) implement the Dodd-Frank Act’s reallocation of regulatory responsibility for investment advisers between the SEC and the states, and (v) amend Form ADV and several Advisers Act rules to reflect the new rules and rules amendments. An outline of key provisions of the adopted rules and rule amendments follows.
Deadline for Registration for Advisers Relying on the Private Adviser Exemption
The Dodd-Frank Act repeals the “private adviser” exemption from registration under the Advisers Act effective July 21, 2011; advisers relying on this exemption would have been required to register with the SEC by such date, unless an exemption from registration is available. The final rules extend the date by which advisers that currently are relying on the private adviser exemption, and cannot rely on another exemption, must register with the SEC to March 30, 2012. The SEC noted in its release adopting the final rules that advisers filing an initial application for registration with the SEC should file a complete application by February 14, 2012, because it can take up to 45 days for the SEC to process an initial application for registration as an investment adviser.1
If an adviser has saved an incomplete Form ADV on the IARD system, the IARD system allows the adviser to store the incomplete Form ADV as “pending” for a period of 120 days. As a result, the IARD system will delete the adviser’s Form ADV if it is not completed and submitted within 120 days of the date the Form ADV was initially stored. Accordingly, advisers that have created a draft Form ADV on the IARD system (and who do not plan to file within 120 days of when the draft was created) may wish to log into the IARD system and download a copy of their draft Form ADV in order to avoid losing it.
Determining Regulatory Assets Under Management
The final rules establish a uniform methodology to be used by advisers to calculate their assets under management for purposes of determining whether they are required to register with the SEC or with state authorities and whether they are able to rely upon the private fund adviser exemption and/or the foreign private adviser exemption, both of which are discussed below. Under the final rules, advisers must calculate their “regulatory assets under management,” which must include all securities portfolios for which an adviser provides continuous and regular supervisory or management services. Regulatory assets under management must include: (i) proprietary assets, (ii) assets managed without compensation, and (iii) assets of non-U.S. clients. Regulatory assets under management must be determined on a gross basis, and accordingly, advisers are not permitted to subtract outstanding indebtedness or other accrued but unpaid liabilities in their calculations.
In addition, all advisers are generally required to use the current market values of securities, rather than cost, in their calculations of regulatory assets under management, provided that advisers may use the fair value of private fund2 assets where market value is unavailable. Under the final rules, an adviser to a private fund must include in its regulatory assets under management (i) the value of any private fund it manages regardless of the nature of the assets held by the private fund, and (ii) the amount of any uncalled capital commitments made to the fund. A sub-adviser to a private fund need only include in its regulatory assets under management the portion of the value of the securities portfolio for which it serves as sub-adviser. The method for calculating regulatory assets under management is set forth in detail in the amended instructions to Part 1A of Form ADV, available here.
Private Fund Adviser Exemption
As required by the Dodd-Frank Act, the SEC adopted Rule 203(m)-1, which exempts from registration under the Advisers Act, any adviser that acts as an adviser solely to one or more qualifying private funds3 and has less than $150 million of regulatory assets under management in the United States. The SEC refers to this as the “private fund adviser exemption.” An adviser that relies upon the private fund adviser exemption must calculate and report to the SEC on Form ADV its regulatory assets under management annually in order to confirm that it remains eligible for the private fund adviser exemption. Once an adviser exceeds $150 million in regulatory assets under management, the adviser is required to register within 90 days after the adviser files its annual Form ADV amendment indicating that it has exceeded $150 million in regulatory assets under management.4
The rule does not restrict the number of private funds that an adviser may advise while relying on the private fund adviser exemption; as long as the adviser’s aggregate regulatory assets under management are below the $150 million limit.
The SEC stated in the adopting release that whether a single investor fund may be considered a private fund for purposes of the private fund adviser exemption will depend on the facts and circumstances of each case. The SEC expressed a concern that some advisers might seek to convert separately managed accounts into single investor funds in order to rely improperly upon the private fund adviser exemption. On the other hand, the SEC acknowledged that there are cases where a bona fide private fund has only one investor: for example, when a fund has just started to raise capital or when all but one of a fund’s investors has redeemed its investment.
Advisers with a principal office and place of business in the United States must count all private fund assets towards the $150 million limit, including assets for which day-to-day management takes place outside of the United States. Advisers with a principal office and place of business outside of the United States must count toward the $150 million limit only those private fund assets that are managed from a place of business in the United States. Accordingly, non-U.S. advisers may qualify for the private fund adviser exemption if they have non-U.S. clients that are not private funds or if they manage in excess of $150 million for non-U.S. clients, as long as (i) the non-U.S. adviser has no client that is a U.S. person except for private funds, and (ii) all assets managed by the adviser from a place of business in the U.S. are attributable solely to private fund assets, the total value of which is less than $150 million.
For purposes of determining whether it has any U.S. clients that are not private funds, a non-U.S. adviser generally applies the definition of “U.S. person” in SEC Regulation S, subject to a special provision designed to prevent non-U.S. advisers from improperly relying upon the private fund adviser exemption by establishing discretionary accounts with a non-U.S. affiliate for the benefit of U.S. clients. The SEC has clarified that a non-U.S. adviser may continue to treat a client that was a non-U.S. person at the time it became a client of the adviser as a non-U.S. client for purposes of the private fund adviser exemption even if the client relocates to the United States. This is intended generally to permit a non-U.S. adviser to continue to rely on the private fund adviser exemption even if it has non-U.S. clients that move to the United States.
Amendments to Form ADV
The final rules amend Form ADV to elicit, among other things, greater information from advisers, including:
All advisers registered with the SEC as of January 1, 2012, must file an amended Form ADV no later than March 30, 2012, regardless of the normal deadline for filing their annual updating amendments to Form ADV.
Eligibility for SEC Registration for Mid-Sized Advisers
The Dodd-Frank Act amends the Advisers Act by generally prohibiting a U.S. investment adviser from registering with the SEC if the adviser: (i) is required to be registered in the state in which it maintains its principal office and place of business, (ii) is subject to examination by the securities regulator of such state by virtue of its registration, and (iii) has assets under management between $25 million and $100 million. Advisers with assets under management between $25 million and $100 million are defined as “mid-sized advisers.” Pursuant to the final rules, the amount of assets under management used to determine if an adviser is a mid-sized adviser is an adviser’s regulatory assets under management calculated as provided above under “Determining Regulatory Assets Under Management.”
Under the final rules, a mid-sized adviser generally must register with the SEC if, under the laws of the state in which its principal office and place of business is located, the adviser relies on an exemption from registration as an investment adviser or is excluded from the definition of investment adviser. Furthermore, a mid-sized adviser is also required to register with the SEC if the adviser is registered with a state, but not subject to examination by such state by virtue of such registration. In the adopting release, the SEC stated that New York and Minnesota advised the SEC that they did not conduct examinations of investment advisers. Therefore, advisers with a principal office and place of business in New York or Minnesota must register with the SEC if they have $25 million or more in assets under management unless an exemption from SEC registration is available. For example, an adviser with its principal office and place of business in New York that advises both private funds and one or more separately managed accounts must register with the SEC upon reaching $25 million in regulatory assets under management. Wyoming does not regulate investment advisers, and so advisers with a principal office and place of business in Wyoming must register with the SEC regardless of their assets under management, unless an exemption from SEC registration is available.
The final rules provide a “buffer” for mid-sized advisers that increases the threshold at which mid-sized advisers generally must register with the SEC to $110 million, although advisers are permitted to register with the SEC upon reaching $100 million in assets under management. Once registered with the SEC, an adviser generally need not withdraw its registration with the SEC until it has less than $90 million of assets under management. The SEC is ending the prior “buffer” for investment advisers with assets under management between $25 million and $30 million.
If a mid-sized adviser that is registered with the SEC on January 1, 2012, is no longer eligible for such registration, the adviser will have until June 28, 2012, to withdraw its registration with the SEC and register with the applicable state securities authorities.
Venture Capital Funds Adviser Exemption
The Dodd-Frank Act provides an exemption from Advisers Act registration for advisers that advise solely venture capital funds and instructs the SEC to define the term “venture capital fund” for purposes of this exemption. Final Rule 203(l)-1 generally defines a “venture capital fund” as a private fund that:
As noted in the second bullet above, Rule 203(l)-1 provides for a “20% basket” of non-qualifying investments.5 The term “qualifying investment” generally is defined as (i) an equity security issued by a qualifying portfolio company that is directly acquired by the private fund from the company (“directly acquired equity”); (ii) an equity security issued by a qualifying portfolio company in exchange for directly acquired equity issued by the same qualifying portfolio company; and (iii) an equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and that is acquired by the fund in exchange for directly acquired equity. The term “qualifying portfolio company” is defined as any company that: (i) at the time of any investment, is not reporting or foreign-traded and does not control, is not controlled by or under common control with a reporting or foreign-traded company; (ii) does not borrow or issue debt obligations in connection with the investment by the private fund and distribute to the private fund the proceeds of any such borrowing or debt issuance in exchange for the private fund investment; and (iii) is not itself a investment company, fund or commodity pool (i.e., is an operating company).
The 20% basket was not contained in the SEC’s release proposing the rule, and is intended to provide greater investment flexibility for venture capital funds while maintaining the scope of the exemption. Under the rule, there is no restriction on the type of investment which may be held by a venture capital fund in its 20% basket. For example, the 20% basket may be used to make occasional debt investments, pursue cash management strategies that involve instruments other than permitted cash items mentioned in footnote 4, or purchase equity securities from other investors in a portfolio company.
The 20% basket is calculated as a percentage of a fund’s total capital commitments. Since total capital commitments generally remain constant during the term of a venture capital fund, this approach is intended to provide venture capital fund advisers with a degree of predictability in managing venture capital funds in compliance with the 20% basket. In calculating whether a venture capital fund complies with the 20% basket, investments may be valued at either their cost or fair value provided the same method is used for all investments made by a venture capital fund throughout its term. Venture capital funds are required to calculate their compliance with the 20% basket whenever they acquire a non-qualifying investment (other than a permitted short-term holding). This is designed so that a fund, after acquiring a non-qualifying investment, need not dispose of it simply because it increases in value, or other investments decrease in value, so that it represents more than 20% of total fund capital commitments.
The SEC did not include in the “venture capital fund” definition a requirement that venture capital funds or their advisers provide management assistance to their portfolio companies. Nor did the SEC limit the venture capital fund exemption to advisers with their principal offices and places of business in the United States. However, a non-U.S. adviser may only rely on the venture capital fund exemption if all its clients, including both U.S. and non-U.S. clients, are venture capital funds.
The final rule contains a grandfathering provision that includes, in the definition of “venture capital fund,” funds that (i) represented to investors and potential investors at the time they offered their securities that they pursued a venture capital strategy, (ii) sold securities to one or more unaffiliated investors prior to December 31, 2010 and (iii) do not sell any securities to, or accept any capital commitments from, any person after July 21, 2011. However, a fund that meets these conditions may continue to rely upon the grandfathering provision even if it draws down its capital commitments after July 21, 2011.
Foreign Private Adviser Exemption
The Dodd-Frank Act established a new exemption from Advisers Act registration for “foreign private advisers.” A foreign private adviser is any investment adviser that: (i) has fewer than 15 clients in the United States and investors in the United States in private funds advised by the adviser, (ii) has less than $25 million in aggregate assets under management from United States clients and private fund investors, (iii) does not have a place of business in the United States, (iv) does not hold itself out generally to the public in the United States as an investment adviser, and (v) does not advise an investment company registered under the Investment Company Act or an entity that has elected to be treated as a business development company under the Investment Company Act.
Final Rule 202(a)(30)-1 defines some of the terms used by the Dodd-Frank Act in the “foreign private adviser” definition and includes a safe harbor and rules for counting clients. Under the rule:
The SEC noted that it has, under the Dodd-Frank Act, authority to increase the $25 million limit in the foreign private adviser exemption and that several commenters urged it to exercise this authority. The SEC reported that it has not, in connection with this rulemaking, considered increasing the $25 million limit. Helpfully, the SEC indicated that it would evaluate whether doing so may be appropriate in the future.
Preservation of Unibanco
There has been some concern as to the impact of the Dodd-Frank Act upon the Unibanco line of no-action letters, which in broad terms permits non-U.S. investment advisers, subject to certain conditions, to have affiliated SEC-registered advisers without themselves becoming subject to Advisers Act registration requirements. The SEC confirmed in the adopting release that nothing in the rules adopted on June 22, 2011, is intended to withdraw any guidance previously provided by its staff in the Unibanco line of no-action letters.6 Less helpfully, the adopting release observes the Unibanco line of no-action letters was developed in the context of the soon-to-disappear private adviser exemption and that the SEC staff will provide future guidance on the application of the Unibanco no-action letters in the context of the new foreign private adviser exemption and private fund adviser exemption.
Reporting by Exempt Reporting Advisers
Under the Dodd-Frank Act, advisers relying on the exemption for private fund advisers or for venture capital fund advisers are subject to some, but not all, of the reporting requirements that apply to registered advisers under the Advisers Act. The SEC refers to these exempt advisers as “exempt reporting advisers.” The SEC, rather than developing a new form for reporting by exempt reporting advisers, has determined to require them to file Part 1A of Form ADV in much the same manner as advisers registered under the Advisers Act, although exempt reporting advisers are required to respond to only some, but not all, of the questions in Part 1A of Form ADV, including:
Exempt reporting advisers, like registered advisers, will be required to file updating amendments to reports filed on Form ADV at least annually, within 90 days of the end of the adviser’s fiscal year, and more frequently, if required by the instructions to Form ADV. Exempt reporting advisers, like registered advisers, also are required to update promptly Items 1 (Identification Information), 3 (Form of Organization) and 11 (Disciplinary Information) if they become inaccurate in any way, and to update Item 10 (Control Persons) if it becomes materially inaccurate. Exempt reporting advisers must also complete the corresponding sections of Schedules A, B, C and D to Form ADV.
As with registered advisers, exempt reporting advisers must file Form ADV through the IARD system and their filings will be made available to the public. Exempt reporting advisers generally are required to file their first reports within 60 days of relying on the exemption from registration that accords them exempt reporting adviser status. Notwithstanding this requirement, exempt reporting advisers must complete and file their initial Forms ADV no later than March 30, 2012. Exempt reporting advisers also will be subject to certain recordkeeping requirements under the Dodd-Frank Act, which the SEC will address in a future release.
During the meeting adopting the new rules and rule amendments, the SEC indicated that, while it has authority to inspect exempt reporting advisers, it does not intend to conduct routine examinations of exempt reporting advisers. However, the SEC may inspect exempt reporting advisers where warranted by particular circumstances.
Amendments to the Pay-to-Play Rule
The SEC adopted amendments to Rule 206(4)-5, or the “Pay-to-Play” rule, which addresses political contributions by investment advisers and some of their associated persons. The amendment broadens the scope of the Pay-to-Play rule, so that the rule applies to exempt reporting advisers and foreign private advisers. In addition, the amendments to the rule add registered “municipal advisors” to the categories of regulated entities that an adviser is permitted to compensate for soliciting government entities for investment advisory mandates. To qualify for the exemption, the registered municipal advisor must register with the SEC pursuant to Section 15B of the Securities Exchange Act and be subject to the Municipal Securities Rulemaking Board’s pay-to-play rules.
The date by which advisers must comply with the Pay-to-Play rule’s ban on third-party solicitation has been extended to June 13, 2012.
Family Offices
The Dodd-Frank Act amends the Advisers Act to exclude “family offices” from the definition of investment adviser. The SEC adopted Rule 202(a)(11)(G)-1, which defines a family office as any company that: (i) has no clients other than “family clients,” (ii) is wholly owned by family clients and controlled, directly or indirectly, by “family members” and/or “family entities,” and (iii) does not hold itself out to the public as an investment adviser. The rule also contains grandfathering provisions.
Family Clients and Family Members
To be considered a “family office” under the rule, all of a family office’s investment advisory clients must be family clients, which include: (i) family members and former family members; (ii) any key employees and, as to investments made or committed to while still a key employee, former key employees of the family office; (iii) charities funded exclusively by family clients; (iv) irrevocable trusts in which family clients are the only beneficiaries; (v) irrevocable trusts funded exclusively by family clients in which other family clients and certain charitable and nonprofit organizations are the only beneficiaries; (vi) revocable trusts of which family clients are the sole grantors; (vii) estates of family members, former family members and key employees; and (vii) certain entities wholly owned exclusively by, and operated for the sole benefit of, family clients.
The rule defines “family members” to include all lineal descendants (including by adoption, stepchildren, foster children and individuals that were minors when another family member became a legal guardian of the individual) of a common ancestor (who may be living or deceased), and such lineal descendants’ spouses or spousal equivalents, provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members.
In cases where family offices advise charitable or nonprofit organizations that have received assets from non-family clients in the past, family offices still may claim exclusion from registration and continue to advise the charitable or nonprofit organization until December 31, 2013. Such charitable or nonprofit organization, however, may no longer accept additional assets from non-family clients after August 31, 2011, unless the funds were pledged prior to that date.
Grandfathering Provisions
Pursuant to the rule, the definition of “family office” does not exclude any office which was not registered or required to be registered under the Advisers Act on January 1, 2010, solely because the office provided investment advice to, and was engaged before January 1, 2010, in providing investment advice to: (i) officers, directors or employees of the office who had invested with the office before January 1, 2010, and who are accredited investors; (ii) companies owned exclusively and controlled by one or more family members; or (iii) certain investment advisers that provide advice or investment opportunities to the office and whose assets represent, in the aggregate, not more than 5% of the value of the total assets as to which the office provides investment advice. An office that meets the grandfathering requirements, but does not otherwise meet the definition of family office, would be subject to the general anti-fraud provisions of the Advisers Act.
The SEC has delayed registration for family offices currently exempt from registration and that do not meet the new family office exclusion or another exemption from registration, until March 30, 2012.
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The release adopting the final rules concerning the private fund adviser, venture capital fund adviser and foreign private adviser exemptions from registration under the Advisers Act may be found here. The release adopting the final rules regarding the deadline for registration, the amendments to Form ADV and the Pay-to-Play rule and the reporting requirements for exempt reporting advisers may be found here. The release adopting the final rule defining “family offices” may be found here.
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This article was originally published by Bingham McCutchen LLP.