The Securities and Exchange Commission (the "Commission") recently published the text of the new Rule 203(b)(3)-2 (the "New Rule 203") and amendments to existing rules, adopted on October 26, 2004, which will require advisers to certain private investment pools, such as hedge funds, to register with the Commission under the Investment Advisers Act of 1940 (the "Advisers Act") by February 1, 2006. The new registration provision will apply only to advisers whose hedge funds accept new money on or after February 1, 2006, from new investors or from those already in the fund, and then, only if the new money is not subject thereafter to a two-year lock up, described below. However, advisers not resident in the United States ("Offshore Advisers") may also be required to register under the New Rule 203.

The Commission release published with the New Rule and the amendments (the "Release") explains the rationale for the introduction of the New Rule 203 to extend to many hedge fund advisers. A copy of the Release is available on the Commission's website at

Effective Dates/Compliance Date

The effective date of the New Rule and most of the amendments is February 10, 2005. Advisers will have until February 1, 2006, however, to register and be in compliance with the New Rule.

Principal Changes Introduced by New Rule 203

As a result of the introduction of the New Rule 203, many investment advisers will no longer be able to avail themselves of the "private advisor exemption". Until February 1, 2006, the Advisers Act exempts an adviser from registration if it (i) had fewer than 15 clients during the preceding 12 months (ii) does not hold itself out generally to the public as an investment adviser, and (iii) is not an adviser to any registered investment company.

As a result of the change, New Rule 203 overturns the past practice for determining what is a "client" and requires investment advisers to "look through" a "private fund" and count each owner of a private fund as a client for the purposes of determining whether they meet the "fewer than 15 clients" exemption. ("Client" for this purpose is generally a client resident in the United States.) "Private fund" is defined to exclude most clients that are business organisations including insurance companies, broker dealers and banks. However, private fund will include many types of pooled investments vehicles investing in securities including "3(c)(1)" and "3(c)(7)" funds (named after their corresponding sections of the Investment Company Act, which except such funds from the definition of "Investment Company" under that statute). Therefore many offshore advisers who advise such funds will be required to look through these funds to determine whether they have 14 or fewer "clients".

The definition of "private fund" is intended to catch all hedge funds that share the same characteristics and will exclude private equity funds.

A fund will not be a private fund unless it is a company that would be subject to regulation under the Investment Company Act but for the exceptions under Section 3(c)(1) and Section 3(c)(7) referred to above.

A fund will be a private fund only if it permits investors to redeem their interests in the fund within 2 years of purchasing them.

A fund will be a private fund only if interests in it are offered based on the investment advisory skills, ability or expertise of the investment adviser.

The SEC will apply the new look-through entity rule only prospectively. Each adviser will need to look through a private fund only as of February 1, 2006 or after to determine whether registration is required.

Impact On Offshore Advisers

Offshore advisers are subject to the same look-through requirements as domestic advisers but unlike domestic advisers they are not subject to the $25 million asset-under-management threshold for registering as an investment adviser under the Advisers Act.

Therefore, unless the offshore adviser adopts the two-year lock-up or can avail itself of certain exceptions to the "private fund" definition it will have to register under the Advisers Act. The investment adviser to a private fund may determine at the time investors invest in the fund whether an investor is a U.S. Client or a non-U.S. client. If an investor is a non-U.S. client at the time of investment the adviser may continue to count the investor as a non-U.S. client even if the investor subsequently relocates to the United States.

The New Rule 203 includes an exception to the definition of "private fund" for a company that has its principal office and place of business outside of the United States, makes a public offering of its securities in a country outside the United States, and is regulated as a public investment company under the laws of the country other than the United States. The exception applies to any type of publicly offered fund, whether in corporate, trust, contractual or other form, so long as the fund is authorised for sale in the same jurisdiction in which it is regulated as a public investment company.

The New Rule 203 limits the extraterritorial application of the Advisers Act that would otherwise occur as a result of the new rule, by providing that an offshore adviser to an offshore private fund may treat the fund (and not the investors) as its client for most purposes under the Advisers Act. Because the SEC does not apply most of the substantive provisions of the Advisers Act to the non-U.S. clients of an offshore adviser and because the offshore fund would be a non-U.S. client, the substantive provisions of the Advisers Act generally would not apply to the offshore advisers dealings with the offshore fund.

The offshore adviser will be required (unless eligible for an exemption) to register under the Advisers Act and to keep certain books and records as required by the rules of the SEC, and will remain subject to examinations by SEC staff. Other requirements, including the Advisers Act's compliance rule, custody rule, and proxy voting rule, would not apply to the registered offshore adviser, assuming it has no U.S. clients other than for counting purposes under the private fund exemption. The registered offshore adviser without U.S. clients (other than for counting purposes) will not be required to adopt a code of the ethics but must retain its access persons' personal securities reports that would otherwise be required under such a code. If, however, the offshore adviser had one U.S. client as a separate account, not only would the offshore adviser have to register under the Advisers Act, but all of the substantive provisions of the Advisers Act would apply.

Action To Be Taken

We recommend to all our clients who are unregistered advisers to private investment funds who were/are currently exempt from registration under Section 203(b)(3) of the Advisers Act to analyse if they shall be required to register with the SEC. If registration is likely, taking into account the date for registration, we urge clients to take immediate action to implement effective procedures for compliance with applicable SEC rules.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.