Many investment advisers to hedge funds, private equity funds and other investment funds currently qualify for exemption from the registration as an investment adviser under the Investment Advisers Act of 1940 (Advisers Act). The Securities and Exchange Commission (SEC) recently proposed a rule that would narrow one important exemption, and if adopted, the rule would require registration of many currently unregistered investment advisers.
Following a heated debate on July 14, 2004 the SEC by a 3-2 vote proposed for comment a new Rule 203(b)(3)-2 under the Advisers Act (See 17 CFR Parts 275 and 279, SEC Release No. IA-2266, Registration Under the Advisers Act of Certain Hedge Fund Advisers, published July 28, 2004 (Proposed Rule). Comments to the Proposed Rule are due by September 15, 2004. After the SEC reviews the comments (which are currently publicly available at www.sec.gov), it will consider changes and could issue a final rule soon thereafter.
Under the current rules, an investment adviser qualifies for exemption from SEC registration if it: (i) advises fewer than 15 clients during the preceding 12 months; and (ii) does not hold itself out publicly as an investment adviser. Currently, Rule 203(b)(3)-1(a)(2)(i) permits many corporations, general partnerships, limited partnerships, limited liability companies, trusts or other legal organizations to be counted as a single “client”. Furthermore, an investment adviser is permitted to count an investment fund as a single client for Advisers Act purposes if the adviser gives securities trading advice based on the fund’s investment goals rather than on the goals of any particular investor in the fund.
The Proposed Rule applies to “private funds,” which are defined to encompass most hedge funds by including any company that relies on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (1940 Act) for exemption from 1940 Act registration. These exclusions are relied upon by most hedge funds to avoid registration with the SEC, and are commonly called “100-Person Fund” and “Qualified Purchaser Fund” exclusions. The funds covered by the Proposed Rule also include funds that permit investors to redeem their ownership interests in the fund within two years of purchasing such interests, and are marketed based on ongoing investment advisory skills, ability or expertise of investment adviser. The reference to the two-year lock-up period requirement is intended to distinguish, for registration purposes, managers of venture capital funds, private equity funds and other similar funds that require investors to make long-term commitments of capital from managers of hedge funds that permit investors to redeem their capital more frequently. A foreign publicly offered fund with its principal place of business located offshore and regulated as a public investment company under a non-U.S. law, will not be considered a “private fund” for the purpose of this new rule.
The Proposed Rule would require investment advisers to look through a private fund and count each beneficial owner of an equity interest in a “private fund” as a “client” for purposes of determining the availability of the private adviser exemption of Section 203(b). Therefore, an adviser who provides investment advice to only one hedge fund with 15 or more investors and which has $30 million or more in assets under management would, under the Proposed Rule, be required to register with the SEC.
Although all advisers, whether or not required to be registered with the SEC, are subject to the Advisers Act’s anti-fraud and anti-manipulation provisions, advisers subject to SEC registration are required to comply with many additional requirements and rules, including: filing with the SEC Form ADV Part 1 that publicly identifies the adviser and distributing to clients Form ADV Part II which must describe potential conflicts of interest of adviser; maintenance of specified books and records; the custody of clients’ securities and funds and periodic reporting related thereto; the disclosure of regulatory and administrative actions; the compliance and the code of ethics rules requiring advisers to adopt extensive policies and procedures detailing advisers’ internal controls; and restrictions on performance fees. For example, under Rule 205-3 of the Advisers Act, registered advisers may only charge “performance fees” (i.e., fees based on fund’s capital gains or appreciation) to “qualified clients” that have net worth of at least $1.5 million USD or have at least $750,000 USD of assets under management with the adviser. As with other SEC’s registration statements and disclosure materials, investment advisers must keep their disclosures current at all times. Investment advisers are also subject to on-site inspection by the SEC, which can occur as frequently as every two years.
In addition to compliance with U.S. federal securities laws, advisers must continue ensuring compliance with various state laws applicable to advisers and their representatives and notice-register in states where advisers are headquartered and/or engage in more than occasional marketing activities. If an adviser has less than $25 million of assets under management, such adviser must only register with the relevant state or states and cannot register with the SEC.
The SEC limited the extra-territorial application of the Proposed Rule by requiring offshore advisers of non-U.S. private funds to “look through” only to U.S. investors and by requiring offshore advisers to comply only with the anti-fraud requirements of the Advisers Act and not all substantive provisions of the Advisers Act, even if the number of U.S. investors would require the offshore advisers to register. This means that, for example, if an offshore adviser with its main place of business outside of the U.S. has within the past 12 months advised an offshore hedge fund with only 13 U.S. investors and 50 non-U.S. investors, regardless of the amount of assets under management, such foreign adviser will not be required to register under the Proposed Rule. Under this caveat, the SEC will permit offshore advisers to treat the fund itself as a single client, except that U.S. investors will be counted for the purpose of determining whether registration of such offshore adviser is required. However, this exemption will not apply to U.S. onshore advisers of offshore funds.
The SEC has provided a transitional mechanism for the regulation of private funds not previously registered with the SEC. The SEC proposes to allow new registrants to retain their investment “track record” and performance information relating to the period prior to registration and would excuse them from SEC recordkeeping rules to the extent that those performance records do not meet the requirements of Rule 204(2). Once registered, a private fund must keep documentation supporting performance claims and comply with the recordkeeping rule going forward. In addition, private funds that would not be permitted to charge performance fees to some of their investors who may not qualify as “qualified clients” would be permitted to maintain existing fee arrangements with persons who had already invested in a private fund prior to adviser’s registration.
If the Proposed Rule is adopted, the SEC estimates that between 690 and 1,260 advisers will be required to register with the SEC, which will significantly increase the SEC’s oversight of currently unregistered hedge fund advisers and the regulatory compliance burden of such hedge fund advisers.