Supplemented on July 28, 2010
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) that reconciled the provisions of the “Wall Street Reform and Consumer Protection Act of 2009” passed by the House of Representatives on December 11, 2009 and those of the “Restoring American Financial Stability Act of 2010” passed by the Senate on May 20, 2010.
The Act will require many U.S. and non-U.S. investment advisers and fund managers to register with the U.S. Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), particularly those advisers that have previously relied on the “private adviser” exemption from SEC registration, which has been eliminated by the Act. The “private adviser” exemption was available to an adviser if, during the preceding 12 months, the adviser advised fewer than 15 clients and neither held itself out generally to the public as an investment adviser nor acted as an investment adviser to any investment company registered under the Investment Company Act of 1940, as amended (the “1940 Act”), or any entity electing to be treated as a business development company under the 1940 Act (each registered fund and business development company under the 1940 Act, a “1940 Act Fund”).
The Act will also impose new disclosure and recordkeeping requirements on many investment advisers, including some that are not required to register with the SEC. Investment advisers that register with the SEC must observe SEC regulations that apply to registered investment advisers. These include, for example, requiring registered advisers to adopt and implement compliance policies and procedures, make and maintain certain books and records, make and maintain publicly available filings with the SEC, accept periodic SEC examinations and adopt and enforce detailed codes of ethics and personal trading rules for their personnel.
Below is a summary of the Advisers Act registration implications of the Act for those advisers that formerly relied on the “private adviser” exemption from Advisers Act registration:
If you are an adviser currently relying on the “private adviser” exemption and you are not prohibited from registering under the Advisers Act (see “State v. SEC Registration” below), then you must register with the SEC as an investment adviser unless:
State v. SEC Registration
The Act maintains the current requirement that U.S. advisers generally must have assets under management of at least $25 million in order to be eligible to register with the SEC. The Act, however, provides that an adviser that (a) is required to be registered in the state in which it maintains its principal office and place of business, (b) if so registered, would be subject to examination by such state and (c) has assets under management between $25 million and $100 million, may not register with the SEC, unless it otherwise would be required to register with 15 or more states or is an adviser to a 1940 Act Fund.2
Except as otherwise noted below, the new requirements will become effective one year after the Act’s enactment.3
Prior to the enactment of the Act, many investment advisers, including advisers to hedge funds, private equity funds and other private investment funds, were exempt from the Advisers Act requirements to register with the SEC. In particular, many investment advisers, including hedge fund and private equity fund managers, relied on the “private adviser” exemption from registration under the Advisers Act. The SEC had taken the position that investment advisers based outside the U.S. needed only count U.S. resident clients towards the 15 client threshold. Accordingly, advisers based outside the U.S. could have many non-U.S. clients and avoid SEC registration requirements if they had fewer than 15 U.S. resident clients. Based on the “private adviser” exemption, U.S. and non-U.S. advisers could manage private investment funds with many U.S. investors without being required to register under the Advisers Act.
Prior to 2004, Rule 203(b)(3)-1 provided that the term “client” for purposes of the “private adviser” exemption referred to each investment fund managed by an adviser and did not require looking through the funds and counting their investors as clients for purposes of the “private adviser” exemption. On December 1, 2004, however, the SEC adopted an amendment to Rule 203(b)(3)-1 to establish the “Hedge Fund Rule” and related amendments that mandated that investment advisers seeking to rely on the “private adviser” exemption “look though” certain funds they managed to count the “shareholders, limited partners, and beneficiaries of the fund” as “clients” for purposes of the “private adviser” exemption if certain conditions were met. This amendment to Rule 203(b)(3)-1 required many hedge fund and other Private Fund advisers previously exempt from Advisers Act registration to register with the SEC. However, in June 2006, the U.S. Court of Appeals for the D.C. Circuit, in the case Goldstein v. SEC,4 ruled that the SEC’s amendment to Rule 203(b)(3)-1 permitting “look through” of entities was inconsistent with the Advisers Act and that “clients” of investment advisers of hedge funds should be interpreted to only include the funds they manage, not the individual investors of the funds. Thus, the Court’s decision allowed many investment advisers of hedge funds and other Private Funds who managed fewer than 15 funds once again to claim the “private adviser” exemption from SEC registration.
Elimination of “Private Adviser” Exemption and Creation of New Narrower Exemptions
The Act, in large part, overturns the Goldstein decision by eliminating the “private adviser” exemption from the registration requirements of the Advisers Act. Within one year after the Act’s enactment, many previously exempt U.S. and advisers of hedge funds, private equity funds and other private investment vehicles will be required to register with the SEC. Certain notable exceptions are provided by the Act and are discussed in detail below.
The SEC may determine that certain Non-U.S. Advisers required to register with the SEC as a result of the Act may not be required to comply with certain rules under the Advisers Act with respect to their non-U.S. clients.8 Although it has not expressed any intention to do so, the SEC may also consider raising the asset threshold for determining “foreign private adviser” status from $25 million to $100 million (or $150 million in the case of a Non-U.S. Adviser that advises only Private Funds) in order to address the discrepancy between the $25 million threshold and the other assets under management registration thresholds discussed above.
In addition, the “family offices” exemption must be available to any person who was exempt from SEC registration prior to January 1, 2010 because such person provides (and was engaged before January 1, 2010 in providing) investment advice solely to: (a) natural persons who invested with the family office prior to January 1, 2010 and were “accredited investors” as defined in Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), and were officers, directors or employees of such family office at the time of their investment, (b) any company owned exclusively and controlled by members of the family of the family office or as the SEC may determine by rule, or (c) any SEC registered investment adviser that: (i) provided investment advice to and identified investment opportunities to the family office and invested in such transactions on substantially the same terms as the family office, (ii) did not invest in other funds advised by the family office and (iii) whose assets as to which the family office directly or indirectly provides investment advice does not represent more than 5% of the value of the total assets as to which the family office provides investment advice.12 Any persons excluded from the definition of “investment adviser” as a result of this exception remain subject to the antifraud provisions of Sections 206(1), 206(2) and 206(4) of the Advisers Act, but not subject to the agency cross and principal transaction restrictions of Section 206(3) of the Advisers Act.
Reporting and Recordkeeping Requirements Relating to Private Funds
The Act authorizes the SEC to require registered investment advisers to maintain such records and file such reports with the SEC regarding Private Funds advised by the investment adviser “as necessary or appropriate in the public interest and for the protection of investors” or to provide the Financial Stability Oversight Council (the “Council”) with the data necessary to monitor systemic risk issues.15
The Act also specifies that each registered investment adviser must maintain the following records and provide the following reports to the SEC with respect to its Private Funds: (a) the amount of assets under management and use of leverage (including off-balance sheet leverage), (b) counterparty credit risk exposure, (c) trading and investment positions, (d) valuation policies and practices of the fund, (e) types of assets held, (f) side arrangements or side letters providing favorable terms for certain investors, (g) trading practices, and (h) all other information that the SEC determines, in consultation with the Council, to be “necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk...based on the type or size of private fund being advised”16
The Act stipulates that the records and reports of a Private Fund advised by a registered investment adviser shall be deemed to be the records and reports of the investment adviser.17 In this way, the Act shifts regulatory responsibility for these records to the registered investment advisers, which are subject to the provisions of the Advisers Act.
The Act also directs the SEC to conduct periodic examinations (the schedule of such examinations is to be established by the SEC) of all records of Private Funds maintained by a registered investment adviser and provides the SEC with ample discretion to conduct such additional or special examinations as the SEC may prescribe as “necessary and appropriate in the public interest, or for the assessment of systemic risk.”18
Information Sharing; Requirement of Confidentiality for Private Fund Information
Pursuant to the Act, the SEC is required to make available to the Council copies of the reports, documents, records and information filed with or provided to the SEC by an investment adviser with respect to a Private Fund. The Act provides that neither the SEC nor the Council may be compelled to disclose this information. However, this confidentiality requirement does not authorize the SEC or the Council to withhold such information from Congress.19 The confidentiality requirement also requires the SEC and the Council to comply with requests for information from any other U.S. federal department, agency or self-regulatory organization or an order of a U.S. court in an action brought by the U.S. government or the SEC. Nonetheless, the Act imposes the same confidentiality requirements as are applied to the SEC and the Council on such other U.S. federal departments, agencies and self-regulatory organizations and exempts the SEC, the Council and other recipients of Private Fund information from the Freedom of Information Act in relation to Private Fund information. Further, the Act states that any “proprietary information” of an investment adviser obtained by the SEC shall be subject to the same limitations on public disclosure as the facts the SEC ascertains during an examination of an adviser (as provided under Section 210(b) of the Advisers Act). “Proprietary information” of an investment adviser as defined by the Act includes sensitive, non-public information regarding: (a) the investment or trading strategies of the investment adviser, (b) analytical or research methodologies, (c) trading data, (d) computer hardware or software containing intellectual property and (e) any additional information the SEC determines to be proprietary. Finally, the Act provides that the SEC may disclose the identity, investment or affairs of any of its clients “for purposes of assessment of potential systemic risk.”Clarification and Extension of SEC Rulemaking Authority
The Act amends Section 211(a) of the Advisers Act to broaden the rulemaking authority of the SEC by permitting the SEC to make rules and regulations defining technical, trade and other terms used in the amendments set forth in Act.20 Consequently, the SEC has discretion to ascribe different meanings to the principal defined terms of the Act in any way it deems necessary. However, the Act expressly limits the SEC’s authority by prohibiting the SEC from defining the term “client” for purposes of the antifraud provisions of Sections 206(1) and (2) of the Advisers Act to include an investor in a Private Fund managed by an investment adviser if such Private Fund has entered into an advisory contract with such adviser. The Act also expressly authorizes the SEC to prescribe registration and examination procedures for advisers to mid-sized Private Funds, taking into account the size, governance and investment strategy of such Private Funds to determine whether they pose systemic risk.21
Other Provisions of Interest
Limitation of Investment by Banking Entities in Hedge Funds and Private Equity Funds. Section 619 of the Act (the “Volcker Rule”) adds a new Section 13 to the Bank Holding Company Act of 1956 that generally prohibits a “banking entity”22 from, among other things, acquiring or retaining ownership interests in “hedge funds” and “private equity funds”23 or from sponsoring such entities (e.g. serving as their general partner or managing member).
An important exception to this general prohibition provides that a banking entity may organize and offer (including sponsor) a private equity or hedge fund to which it provides bona fide trust, fiduciary or investment advisory services provided that such fund is organized and offered only in connection with the provision of such services and only to persons who are customers of such services of the banking entity and so long as the banking entity does not acquire or retain an equity interest, partnership interest or other ownership interest in the fund apart from a “de minimis investment.”24 “De minimis investments” include: (a) the banking entity’s “seed investment” in the fund and (b) other investments in the fund provided that the banking entity: (i) actively seeks third party investment to dilute its investment, (ii) reduces its investment in the fund to 3% or less of the fund’s total ownership interests within one year after the fund’s establishment,25 (iii) makes an investment that is “immaterial”26 to the banking entity and (iv) the aggregate of all the banking entity’s de minimis investments does not exceed 3% of its “Tier I” (core) capital.
Banking entities must comply with the hedge and private equity fund ownership provisions of the Volcker Rule within two years after the effective date of the relevant divestiture requirements (which may be up to two years after the effective date of the Act). This compliance period may be extended by up to three one-year periods by the Board of Governors of the Federal Reserve System (the “Fed”), which may also grant a one time five-year extension for the divestiture of “illiquid funds” held by a banking entity.”27 As a result of these provisions, many banking entities may be required to divest themselves of a substantial portion of their holdings in hedge funds and private equity funds in the future. Advisers to such funds should examine their organizational documents and fund-related contracts (including private “side letter” agreements with their investors in such funds) to determine the applicable procedures to facilitate the sale and transfer of fund interests currently held by investors that are banking entities regulated by the Fed.
The Fed is required to impose additional quantitative limits on the investment in hedge and private equity funds by the nonbank financial companies28 it regulates. These nonbank financial companies must comply with these quantitative limits on hedge and private equity fund investment within the earlier of: (a) two years after the effective date of the relevant divestiture requirements (which may be up to two years after the effective date of the Act) and (b) two years after the date on which an entity or company becomes a non-bank financial company supervised by the Fed. This compliance period may also be extended by up to three one-year periods by the Fed. As a result, many nonbank financial companies regulated by the Fed may also be required to divest certain of their hedge and private equity fund holdings in the future.
A banking entity may act as investment manager to a hedge fund or private equity fund so long as it does not enter into “covered transactions” (as defined in Section 23A of the Federal Reserve Act) with such fund, and the banking entity acts in accordance with Section 23B of the Federal Reserve Act as if such entity was a member bank and such fund was an affiliate. Similar restrictions apply to banking entities that sponsor or organize and offer hedge funds or private equity funds.
Adjustment of “Qualified Client” Test for Inflation.29 Section 205(a) of the Advisers Act generally prohibits registered investment advisers from charging performance fees or similar fees based on the appreciation of the value of assets under management. Rule 205-3 provides an exemption from this prohibition that generally permits registered investment advisers to charge performance fees to “qualified clients.” The rule defines “qualified clients” to include natural persons or companies (a) with at least $750,000 under management with the adviser immediately after entering into such advisory relationship, (b) natural persons with a net worth of more than $1.5 million (including assets held jointly with a spouse), and (c) that are “qualified purchasers” under the 1940 Act (generally individuals with at least $5 million and companies with at least $25 million in dollar amount of “investments” as defined in Rule 2a 51-1 under the 1940 Act). The Act amends Section 205(e) of the Advisers Act to require the SEC to adjust for inflation the $750,000 assets under management and $1.5 million net worth thresholds for determining a client’s status as a “qualified client” within one year after the date of the Act’s enactment and every 5 years thereafter. This change may increase the suitability requirements for many Private Funds managed by an SEC registered adviser and must be reflected in the offer and subscription documents for Private Funds on effectiveness. However, this change will not require an increase in the suitability standards for Private Funds that require their investors to be “qualified purchasers” as defined in Section 2(a)(51) of the 1940 Act because “qualified purchasers” are automatically qualified clients.
Accredited Investor Definition. Rules 215 and 501(a) under the Securities Act define “accredited investors” to include, among others, individual investors with a net worth, or joint net worth with their spouse, that exceeds $1 million. It appears that, effective when the Act became law, individuals were no longer permitted to include the value of their primary residence in determining whether they have sufficient net worth, or joint net worth with their spouse, to meet this test.30 The Act directs the SEC to maintain the net worth threshold at $1 million exclusive of the value of the investor’s primary residence for four years after enactment of the Act and authorizes the SEC to review the definition of “accredited investor” as it applies to natural persons, and to make any adjustments or modifications necessary for the protection of investors, in the public interest and in light of the economy at least once within every four year period, starting four years after the enactment of the Act.31 Advisers should examine the offering documents for Private Funds they manage to ensure that the value of an individual's primary residence is excluded from the calculation of the $1 million net worth threshold.32
Disqualifications From Using Regulation D. Rule 506 under the Securities Act provides an exemption from registration under the Securities Act for certain private offerings and sales of securities, and Section 18(b) of the Securities Act includes among the “covered securities” that are exempt from state regulation of securities offerings, securities offered in Rule 506 exempted offerings. The Act requires the SEC, within one year after enactment, to promulgate rules disqualifying certain persons from using the Rule 506 exemption.33 These persons include (1) a person who is subject to a final order by a state securities, banking or insurance authority, a federal banking agency or the National Credit Union Administration that (a) bars the person from association with any entity regulated by such authority, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or (b) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct within the 10-year period ending on the date of the filing of the Form D relating to the offer or sale, or (2) a person who has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the SEC.
Advisers now relying on the “private adviser” exemption should consider whether they are required to register under the Advisers Act during the one year period before the amendments to the Advisers Act registration requirements will take effect in July 2011. Advisers currently registered with the SEC having less than $100 million in assets under management should consider whether they will be required to transition from SEC registration to registration with one or more U.S. state securities authorities. Further, advisers to hedge funds and private equity funds should consider whether the Volcker Rule may trigger redemptions from these funds by banks and other financial institutions subject to regulation by the Fed. Advisers to Private Funds offered to “accredited investors” should adjust the “accredited investors” wording in their subscription and offer materials to require individual investors to exclude their primary residence when determining if they meet the $1 million net accredited investors test.
The obligations of investment advisers and fund managers under the Advisers Act may evolve as the SEC and other regulators provide guidance and issue rules implementing the Act. We will be monitoring the rulemaking process closely and will discuss further developments in future alerts.
Please direct questions to any of the listed attorneys or to any other Bingham attorney with whom you ordinarily work on related matters:
John Holton, Partner, Investment Management
1The “family office” exemption will also be available to certain persons who provided family office related investment advice prior to January 1, 2010. See “Family Offices Exception” below.
4Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
6The Senate proposal to exempt advisers solely to private equity funds was not included in the Act. However, the exemption for advisers to “venture capital funds” may ultimately exempt some private equity fund managers once the SEC defines the term.
8 The SEC has previously permitted a “regulation lite” approach that registered Non-U.S. Advisers may observe with respect to their non-U.S. clients (including, without limitation, non-U.S. funds in which U.S. persons invest). Under the “regulation lite” regime, a Non-U.S. Adviser is permitted to treat each non-U.S. fund as its "client" for all purposes of the Advisers Act, except for Sections 203, 204, 206(1) and 206(2) thereof. As a result, most of the substantive provisions of the Advisers Act would not apply to a Non-U.S. Adviser's dealings with a non-U.S. fund, even if the investors in the fund included U.S. persons. For example, a Non-U.S. Adviser would not be required to comply with the following rules under the Advisers Act as to non-U.S. clients: (a): Rule 206(4)-7 (the “compliance” rule), (b) Rule 206(4)-2 (the “custody” rule) and (c) Rule 206(4)-6 (the “proxy voting” rule).
19§404. The Act also requires the SEC to report annually to Congress on how the SEC has used the data it has collected to monitor the markets for the protection of investors and the integrity of the markets (§404).
22“Banking entity” is defined in §619 to include: (a) any insured bank, savings association or nonbank entity corporation deemed to be operating in substantially the same manner as a savings association jointly by such entity and the Director of the Office of Thrift Supervision, (b) any company that controls an entity described in (a), (c) a company that is treated as a bank holding company under Section 8 of the International Banking Act of 1978, and (d) any affiliate of any entity in (a)-(c).
23“Hedge funds” and “private equity funds” are defined in §619 to include Private Funds or such similar funds as the appropriate Federal banking agencies, the SEC and the CFTC may determine by rule.
24The banking entity and/or its affiliates will also need to comply with additional restrictions set forth in the Volcker Rule. These restrictions include: (a) a ban on guarantees by the banking entity of the obligations or performance of the fund, (b) certain trading restrictions between the banking entity and the fund, (c) written disclosure by the banking entity that the fund’s investors (and not the banking entity) are responsible for the losses of the fund, (d) a prohibition on the use of the same name (or a variant thereof) by the banking institution and the fund and (e) a prohibition on the ownership of equity interests in the fund by directors or employees of the banking entity (except for those who are directly engaged in providing investment advisory or other services to the fund).
25This divestiture requirement may be extended for a period of two years by the Board of Governors of the Federal Reserve System if it determines that such extension is consistent with safety and soundness and in the public interest and
26Such term shall be defined under the Act by the applicable federal banking agencies, the SEC and/or the CFTC.
27The Volcker Rule defines “illiquid fund” as a hedge fund or private equity fund that, as of May 1, 2010 was principally invested in (or contractually committed to invest in) illiquid assets (undefined) such as portfolio companies, real estate investments and venture capital investments and makes all investments pursuant to, and consistent with, an investment strategy to principally invest in illiquid assets.
28As defined in §102 to include U.S. and foreign companies (excluding bank holding companies, national securities exchanges and such other entities described in §102) that derive 85% or more of their gross revenues (directly or indirectly) from “activities that are financial in nature” (as such phrase is defined Section 4(k) of the Bank Holding Company Act of 1956) or from the ownership or control of one or more insured depository institutions.
32It appears that, subject to implementation of any new rules (or revisions to existing rules) adopted by the SEC as a result of the Act, any indebtedness secured by the primary residence (but only up to the fair market value of such residence) also my be excluded for purposes of the $1 million net worth test. Along those lines, it appears that any indebtedness secured by the investor's primary residence that exceeds the fair market value thereof should be treated as a liability and, accordingly, deducted for purposes of calculating the investor's net worth.