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Private Fund Investment Advisers Registration Act of 2010
July 1, 2010
On June 30, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") passed the House of Representatives and is now heading to the Senate floor with the expectation of enactment soon after the Independence Day holiday. Title IV of the
Dodd-Frank Act codifies the Private Fund Investment Advisers Registration Act of 2010 (the "Registration Act"), which significantly alters the regulatory landscape for advisers to certain private funds. Not only does the Registration Act change investment adviser registration requirements and exemptions under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), it also shifts the jurisdiction for federal and state responsibilities in regulating investment advisers, mandates additional governmental studies and rulemaking regarding private funds and increases regulation of private funds managed by investment advisers registered with the Securities and Exchange Commission (the "SEC") by requiring records and reports of those funds and increasing thresholds for fund investor qualifications. A summary of the material provisions of the Registration Act, as reported by the committee of conference and passed by the House, are set forth below.
SEC Investment Adviser Registration
Limited Intrastate Registration Exemption. Currently, the Advisers Act exempts from SEC registration any investment adviser all of whose clients are residents of the state within which such investment adviser maintains his or its principal office and place of business, and who does not furnish advice or issue analyses or reports with respect to securities listed or admitted to unlisted trading privileges on any national securities exchange. The Registration Act would limit this exemption to any investment adviser that does not act as an investment adviser to any "private fund," defined as any issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940, as amended (the "Investment Company Act") but for sections 3(c)(1) or 3(c)(7) of the Investment Company Act. This change to the Advisers Act effectively eliminates the availability of the intrastate exemption for private fund advisers all of whose clients are within the adviser's home state.
Elimination of Private Adviser Registration Exemption. Many advisers to private funds currently rely on the "private adviser" exemption from registration under Section 203(b) of the Advisers Act for advisers with fewer than fifteen clients—where the term "clients" is defined in a way that allows each fund to be counted as a single client without looking through and counting the fund's underlying investors. The Registration Act would eliminate this exemption and replace it with a limited exemption for certain "foreign private advisers," who include any investment adviser that has:
- no place of business in the United States
- in total, fewer than fifteen clients (with an investment fund and its investors each counting as one client) in the United States
- aggregate assets under management ("AUM") attributable to clients (including both investment funds and their investors) in the United States of less than $25 million, or such higher amount as the SEC may deem appropriate; and
- holds itself out generally to the public in the United States as an investment adviser;
- acts as an investment adviser to any investment company registered under the Investment Company Act; nor
- acts as a company that has elected to be a business development company pursuant to the Investment Company Act and has not withdrawn its election.
All investment advisers to private funds who do not meet the definition of a foreign private adviser and who are subject to the jurisdiction of the SEC would need to register with the SEC unless another exemption is available. Notably, the Registration Act does not expressly authorize the SEC to adopt different registration and examinations procedures for foreign advisers not otherwise meeting the definition of foreign private advisers, meaning they would be subject to the full panoply of compliance, record-keeping and examination/inspections requirements currently mandated for all U.S.-based registered investment advisers.
Limited CTA Registration Exemption. Currently, any investment adviser that is registered with the Commodities Futures Trading Commission ("CFTC") as a commodity trading advisor whose business does not consist primarily of providing securities-related advice is exempt from SEC registration (unless such adviser acts as an investment adviser to an investment company or a business development company). The Registration Act would limit this exemption such that any CFTC registered investment adviser that advises a private fund must register with the SEC if, after the date of the enactment of the Investor Protection and Securities Reform Act of 2010 (Title IX of the Dodd-Frank Act), the business of the adviser consists predominately of providing securities-related advice. The Registration Act does not define "predominately."
SBIC Registration Exemption. The Registration Act adds an exemption for any investment adviser, other than a business development company, who solely advises:
- small business investment companies ("SBICs") that are licensees under the Small Business Investment Act of 1958, as amended ("SBIA");
- entities that have received from the Small Business Administration notice to proceed to qualify for a license as an SBIC under the SBIA, which notice or license has not been revoked; or
- applicants affiliated with one or more licensed SBICs and that have applied for another license under the SBIA, which application remains pending.
Venture Capital Fund Adviser Registration Exemption. Investment advisers that act as investment advisers solely to one or more "venture capital funds" (as such term is to be defined by SEC rulemaking within one year of the Registration Act's enactment) would be exempt from registration requirements. These advisers, however, must maintain such records and provide to the SEC such annual or other reports as the SEC determines necessary or appropriate in the public interest or for the protection of investors.
Private Fund Adviser with U.S. AUM of less than $150 million Registration Exemption. The Registration Act requires the SEC to provide an exemption from registration to any investment adviser that acts solely as an adviser to private funds and has AUM in the United States of less than $150 million. These advisers, however, must maintain such records and provide to the SEC such annual or other reports as the SEC determines necessary or appropriate in the public interest or for the protection of investors. To qualify for this exemption the private fund adviser must otherwise be subject to SEC registration (see State and Federal Responsibilities below).
Registration and Examination of Mid-Sized Private Fund Advisers. In prescribing regulations under the Registration Act, the SEC must take into account the size, governance, and investment strategy of mid-sized private funds to determine whether they pose systemic risk. The SEC also must provide for registration and examination procedures that reflect the level of systemic risk posed by such private funds. The Registration Act does not define "mid-sized" private funds.
Family Office Exclusion from the Definition of Investment Adviser. Family offices (as such term is to be defined by SEC rulemaking) are excluded from the definition of "investment adviser" and, therefore, not subject to regulation as investment advisers under the Advisers Act. The SEC's definition of "family office" must:
- be consistent with the SEC's previous exemptive policy for family offices;
- recognize the range of organizational, management and employment structures and arrangements employed by family offices; and
- must include a grandfathering provision for everyone who was not registered or required to be registered under the Advisers Act on January 1, 2010, solely because it provides investment advice to (and was engaged before January 1, 2010): (i) natural persons who are officers, directors or employees of the family office who have invested with the family office before January 1, 2010 and are accredited investors as defined by Regulation D under the Securities Act of 1933, as amended (the "Securities Act"); (ii) any company owned exclusively and controlled by members of the family of the family office, or as the SEC may prescribe by rule; and (iii) any SEC registered investment adviser that provides investment advice and identifies investment opportunities to the family office, invests in these opportunities on the same terms as the family office invests, does not invest in other funds advised by the family office, and whose assets as to which the family office directly or indirectly provides investment advice represent not more than five percent of the value of the total assets as to which the family office provides investment advice.
Importantly, any family office that would not fall within the SEC's definition of "family office" but for the grandfathering provision set forth above would still be deemed an investment adviser for purposes of the anti-fraud provisions of the Advisers Act.
State and Federal Responsibilities—$100 Million Threshold
Currently, the Advisers Act provides that an investment adviser is subject to regulation by the securities regulator in each state where it maintains a place of business or where during the preceding twelve month period it had had more than five clients. In states that have enacted an investment adviser statute, an investment adviser must register with the applicable state(s), unless an exemption from registration is available. However, if an investment adviser has over $25 million of AUM (or such higher amount as determined by the SEC by rule) (the "$25 Million Threshold"), the investment adviser may choose to register with the SEC instead of the state securities regulator(s). Once an investment adviser has $30 million or more of AUM, it must register with the SEC, unless an exemption from registration is available, and may then withdraw its registration with the state securities regulator(s), if any. Notwithstanding the $25 Million Threshold, an investment adviser must register with the SEC, unless an exemption from registration is available, if upon submission of its application for SEC registration it is required to register with the securities regulators of thirty or more states, and thereafter would be required to register with the securities regulators of at least twenty five states (or at least twenty five states in the case of an amendment to Form ADV).
The Registration Act would expand the current prohibition on SEC registration to an investment adviser who:
- is required to be registered with the state securities regulator in the state where it maintains its principal office and place of business, and if registered, would be subject to examination as an investment adviser by such regulator; and
- has AUM above the $25 Million Threshold, but below $100 million of AUM (or such higher amount as determined by the SEC by rule) (the "$100 Million Threshold").
This expanded prohibition would not apply to an adviser to an investment company registered under the Investment Company Act or a company which has elected to be a business development company and has not withdrawn the election. In addition, if an investment adviser would be required to register with fifteen or more states because of the $100 Million Threshold, the adviser may register with the SEC notwithstanding the expanded prohibition.
Collection of Systemic Risk Data; Reports; Exams; Disclosures
The Registration Act would authorize the SEC to require SEC registered investment advisers to private funds to maintain records of, and file with the SEC, reports regarding such private funds as necessary and appropriate in the public interests and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council (the "Council") created under the Dodd-Frank Act. All records and reports of private funds maintained by an investment adviser under the Registration Act would be deemed to be the records and reports of the investment adviser and would be subject to periodic and special examination by the SEC. The records and reports must include the following information for each private fund:
- amount of AUM;
- use of leverage (including off-balance sheet leverage);
- counterparty credit risk exposures;
- trading and investment positions;
- valuation policies and practices of the fund;
- types of assets held;
- side arrangements or side letters;
- trading practices; and
- such other information as the SEC, in consultation with the Council, determines.
The records and reports may include different requirements for different classes of fund advisers, based on the type or size of private fund being advised.
The SEC must make all records and reports available to the Council as are necessary for the purpose of assessing systemic risk. The SEC would also have to report annually to Congress on how the SEC has used the data collected to monitor the markets for the protection of investors and the integrity of the markets.
The Registration Act requires all information obtained by the Council or any other department, agency, or self-regulatory organization from the SEC to be kept confidential and specifically exempts the SEC, the Council and any other such organization from the disclosure requirements of The Freedom of Information Act (FOIA) with respect to such information. The Registration Act provides that neither the SEC, the Council nor any other such organization could be compelled to disclose information contained in any filed report. However, the Registration Act does not authorize the SEC, the Council or any other such organization to withhold information from Congress upon an agreement of confidentiality; or prevent the SEC, the Council or any other such organization from complying with a request for information from any other federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction or an order of a court of the United States in an action brought by the United States, the SEC, the Council or any other such organization.
The Registration Act would restrict the SEC’s ability to make public any proprietary information of an investment advisers obtained from any filed report, except in the case of a public hearing, in the case of a resolution or request from Congress, as may be necessary or appropriate in an Advisers Act enforcement proceeding or investigation, or for purposes of assessing potential systemic risk. For purposes of this provision, "proprietary information" includes sensitive, non-public information regarding:
- the investment or trading strategies of the investment adviser;
- analytical or research methodologies;
- trading data;
- computer hardware or software containing intellectual property; and
- any additional information that the SEC determines to be proprietary.
Further expanding the SEC's disclosure authority, the Registration Act would add an additional exception to Section 210(c) of the Advisers Act, which currently restricts the SEC’s ability to require advisers to disclose the identity, investments, or affairs of any client. The new exception to the restriction on SEC disclosures would apply to disclosures made for the purpose of assessing potential systemic risk.
The Registration Act requires investment advisers registered with the SEC to take such steps to safeguard client assets over which the adviser has custody, including without limitation, verification of such assets by an independent public accountant, as the SEC may by rule prescribe. The current custody rules (Rule 206(4)-3, effective as revised on March 12, 2010) were promulgated under Section 206(4) of the Advisers Act, which directs the SEC to define by rule and prescribe means reasonably designed to prevent, such acts, practices and courses of business as are fraudulent, deceptive or manipulative. Noncompliance with Rule 206(4)-3 while an adviser has custody of client funds or securities is a fraudulent, deceptive or manipulative act, practice or course of business. This new authority for custody may be merely belt and suspenders for the current authority under Section 206(4).
Accredited Investor Standard
The Registration Act requires the SEC to adjust the net worth standard for an accredited investor under Regulation D of the Securities Act. The individual net worth standard of any natural person, or joint net worth with the spouse of that person, at the time of purchase, would be more than $1 million, excluding the value of the primary residence. Although the $1 million standard would be subject to periodic adjustment by the SEC (see GOA/SEC Studies and Rulemaking below), the SEC would not be able to adjust the standard for the first four years from the date of the Registration Act's enactment. The standard would apply to new investors and to current investors making additional purchases unless the SEC otherwise provides by rule or order.
Qualified Client Standard
The Registration Act requires the SEC to adjust by order any dollar amount test it uses for purposes of Advisers Act Section 205(e), including the "qualified client standard" set forth in Rule 205-3 (Exemption from the Compensation Prohibition of Section 205(a)(1) for Investment Advisers), for inflation not later than one year after the Registration Act's enactment and every five years thereafter. Adjustments must be made in multiples of $100,000.
Driving home the point that financial regulatory reform has not been analyzed from every possible angle, the Registration Act sets forth the following studies:
- required Comptroller General study of the compliance costs associated with the current custody rules and the additional costs if the requirements relating to operational independence were eliminated, with a report due not later than three years after enactment;
- optional review of the definition of "accredited investor" as it applies to natural persons to determine whether the requirements of the definition, other than the requirement relating to the net worth standard, should be adjusted or modified;
- required review of the definition of "accredited investor" as it applies to natural persons in its entirety not earlier than four years after enactment and not less frequently than once every four years thereafter;
- required Comptroller General study on the appropriate criteria for determining the financial thresholds or other criteria to qualify for accredited investor status and eligibility to invest in private funds, with a report due no later than three years after enactment;
- required Comptroller General study on the feasibility of forming a self-regulatory organization to oversee private funds, with a report due not later than one year after enactment;
- required SEC Division of Risk, Strategy and Financial Innovation study on the state of short selling on national securities exchanges and in the over-the-counter markets, with a report due no later than two years after enactment;
- required SEC Division of Risk, Strategy and Financial Innovation study on the feasibility, benefits and costs of requiring reporting of short positions in real time publicly or only to the SEC and the Financial Industry Regulatory Authority, with a report due no later than one year after enactment; and
required SEC Division of Risk, Strategy and Financial Innovation study on the feasibility, benefits and costs of conducting a voluntary pilot program to have all trades of public company shares marked "short," "market maker short," "buy," "buy-to-cover," or "long" and reported in real time through the consolidated tape, with a report due no later than one year after enactment.
The sweeping financial regulatory reform encompassed by the Registration Act is only the end of the bringing, as the SEC now must start its rulemaking process and issue rules covering the following directives set forth in the Registration Act:
- not later than one year after enactment, the SEC must issue final rules to define the term "venture capital fund;"
- provide an exemption for advisers to private funds with United States AUM of less than $150 million (no specified timing);
- provide registration and examination procedures for advisers to mid-sized private funds (no specified timing);
- provide for a definition of "family office" (no specified timing);
- upon completion of an optional review of the definition of "accredited investor" the SEC may make adjustments to the definition, other than adjusting or modifying the requirement relating to the net worth standard as such term applies to natural persons, for the protection of investors, in the public interest and in light of the economy;
- upon completion of a required review of the definition of "accredited investor" the SEC may make adjustments to the definition for the protection of investors, in the public interest and in light of the economy; and
not later than twelve months after the date of enactment, the SEC and the CFTC must jointly issue rules to establish the form and content of the reports required to be filed with the SEC under Section 204(b) of the Advisers Act and with the CFTC by dually registered investment advisers.
If the House version of the Dodd-Frank Act passes the Senate, the Registration Act will become effective one year after its enactment. Investment advisers seeking to voluntarily register prior to the enactment date may do so subject to the rules of the SEC.