Background
Industry veterans will remember the 2004 attempt of the U.S.
Securities and Exchange Commission (the "SEC") to
regulate fund managers. At that time, the SEC attempted to alter
the rules investment advisers to funds were required to use to
count clients. This represented the SEC's indirect attempt to
deprive fund managers of the ability to rely on the so-called
"Private Adviser Exemption" for investment advisers with
fewer than 15 clients. Much to the relief of the funds industry,
the U.S. Court of Appeals for the District of Columbia found that
the SEC had exceeded its authority and nullified the new rule in a
case styled Goldstein v. Securities & Exchange
Commission.
As a result of the numerous scandals involving funds and investment
advisers, there is a renewed effort to regulate fund managers. This
time, the U.S. Congress is leading the charge. As such, there is
little likelihood that the funds industry will get a last-minute
judicial reprieve as it did in 2004. Under the current legislative
proposals, rather than manipulating the manner in which clients are
counted for purposes of the Private Adviser Exemption, the U.S.
Investment Advisers Act of 1940 (the "Advisers Act")
would be amended to eliminate the Private Adviser Exemption in its
entirety.
On December 11, 2009, the full U.S. House of Representatives passed
The Wall Street Reform and Consumer Protection Act of 2009. On May
20, 2010, the full Senate passed The Restoring American Financial
Stability Act. The versions of the legislation passed by the House
of Representatives and Senate have been referred to Conference
Committee where differences between the two proposals will be
resolved prior to submitting final legislation to President Obama
for signature. Based on the most recent reports, it is anticipated
that the a final version of the amendments to the Advisers Act will
be approved by both houses of Congress and signed by President
Obama prior to the 4th of July Congressional recess. Once final
legislation is enacted, implementation of the amendments to the
Advisers Act will require a SEC rulemaking proceeding. It is
anticipated that the SEC rulemaking proceeding will be completed
within 12 months and the amendments to the Advisers Act will,
therefore, be effective by mid-2011.
Non-U.S. funds managers should be aware that it is a stated purpose
of these legislative proposals to expand the number of non-U.S.
funds that are subject to registration with and regulation by the
SEC.
The Current Private Adviser Exemption
Under current law, and until the effective date of the proposed
amendments to the Advisers Act discussed in greater detail below,
Advisers Act Section 203(b)(3) provides an exemption from
registration for investment advisers with a limited number of
clients. Advisers Act Section 203(b)(3) states, in relevant part,
that the registration requirements of the Advisers Act will not
apply to:
Any investment adviser who during the course of the preceding
12 months has had fewer than 15 clients and who neither holds
himself out generally to the public as an investment adviser nor
acts as an investment adviser to any investment
company....
Again under current rules, fund managers are generally allowed
to treat a fund as a single client, as opposed to each of the
individual investors in the fund being treated as a separate
client. Under Advisers Act Rule 203(b)(3)-1, any trust or other
legal organization such as a corporation, limited partnership,
limited liability company or their non-U.S. equivalents can be
treated as a single client so long as the fund manager provides
investment advice based on the investment objectives of the legal
organization rather than the individual investment objectives of
its shareholders, partners, members or beneficiaries. The ability
to count a fund, as opposed to fund investors, as clients has
allowed nearly all fund managers of privately-placed funds to avoid
regulation under the Advisers Act.
Further, under current Advisers Act Rule 203(b)(3)-1(b)(5), any
fund manager that advises multiple funds and maintains its
principal place of business outside the U.S. is required to count
only "U.S. resident clients" against the 15-client
limitation. Although Advisers Act Rule 203(b)(3)-1(b)(5) uses the
term "U.S. resident client", that term is not
specifically defined in the Advisers Act or the rules promulgated
thereunder. The most recent guidance the SEC has provided as to the
meaning of "U.S. resident client" under the Advisers Act
can be found in an SEC adopting release for the proposed hedge fund
registration rule that was struck down in the Goldstein
decision.
In the adopting release, the SEC acknowledged that there was no
adequate definition of "U.S. resident client" under the
Advisers Act and that this definition should be the subject of a
future rulemaking proceeding. However, the SEC went on to say that
until such a rulemaking was undertaken, it would not object if the
status of a client as a "U.S. resident client" were
determined as follows:
- A natural person will be a U.S. resident client if their permanent residence is in the U.S.;
- A corporation or other business entity (including a business trust) will be a U.S. resident client if the business entity's principal office and place of business is located in the U.S.;
- A personal trust or estate will be a U.S. resident client if any of the trust's trustees or the estate's executors or administrators is a natural person whose principal residence is in the U.S. or a business entity organized under the laws of the U.S. or whose principal office or place of business is located in the U.S.; and
- In the case of any discretionary or non-discretionary managed account, the status of the person or persons for whose benefit the amount is held.
The significance of the current definition of a "U.S. Resident Client" will become apparent when we discuss the definition of a "Foreign Private Adviser" below.
The Proposed Amendments
Both The Wall Street Reform and Consumer Protection Act of 2009
and The Restoring American Financial Stability Act will amend the
Advisers Act to, among other things, eliminate the Private Adviser
Exemption. Both of these proposals will replace the current
exemption based on the number of clients with an exemption based on
the amount of assets under management ("AUM"). Both of
the proposals will also create new exemptions for a "Foreign
Private Fund Adviser." The definition of Foreign Private Fund
Adviser will be discussed in greater detail below.
For any non-U.S. fund manager that fails to meet the definition of
a Foreign Private Fund Adviser, they will be subject to the same
rules as are applicable to U.S. fund managers. Under The Wall
Street Reform and Consumer Protection Act of 2009, a fund manager
would be required to register with the SEC under the Advisers Act
if they advise one or more funds with $150 million or more in AUM.
The Restoring American Financial Stability Act would set the
registration threshold at $100 million.
Registration under the Advisers Act would require fund managers to
file a Form ADV, together with annual updates, with the SEC. The
Form ADV, which includes information on structure, ownership and
the amount of AUM, is publicly available on the SEC's website
in an electronically searchable format. Registration under the
Advisers Act will also subject fund managers to other regulatory
requirements, including, without limitation, requirements to
appoint a chief compliance officer, adopt a Code of Ethics and
other policies and procedures required by the SEC and comply with
the SEC's newly-enhanced custody rules. Registered fund
managers will also be subject to periodic SEC examinations and be
required to comply with SEC mandated recordkeeping requirements.
With regard to SEC examinations and record keeping requirements,
you should be aware that the records of the underlying funds
advised by a registered fund manager would also generally be
subject to such examination and record keeping requirements.
Definition of Foreign Private Fund Adviser
A Foreign Private Fund Adviser is defined as any investment
adviser who (i) has no place of business in the U.S., (ii) has
fewer than 15 U.S. clients, (iii) has less than $25 million in AUM
attributable to clients in the U.S. and (iv) does not hold itself
out generally to the U.S. public as an investment adviser. It is
significant to note that under the proposed definition of Foreign
Private Fund Adviser, a fund manager that has any place of business
in the U.S. will automatically fail the test. This differs from
current rules under which the operative test is the fund
manager's principal place of business.
However, perhaps the most significant aspect of the definition of
Foreign Private Fund Adviser is the phrase "attributable to
clients in the U.S." Neither of the legislative proposals
attempts to define the phrase "attributable to clients in the
U.S." Rather, both proposals leave the definition of that
phrase to a future SEC rulemaking proceeding. Although we cannot
state with any certainty how the SEC will ultimately define the
term "attributable to clients in the U.S.," it seems
likely that the SEC will adopt a new set of rules for determining
the status of U.S. clients in a way that expands the number of
non-U.S. fund managers that are subject to registration with and
regulation by the SEC. For example, the SEC may adopt look through
rules that would determine U.S. status:
- In the case of a corporation or other business entity, by reference to the status of its officers, directors and/or owners (rather than its principal office and place of business);
- In the case of personal trust, by references to the status of its settlors and/or beneficiary(ies) in addition to, or rather than, its trustee(s); and
- In the case of managed accounts, by reference to the status of the account manager(s) in addition to the account owners.
Additionally, the SEC could adopt attribution rules that would require all of the assets of a fund to be treated as attributable to clients in the U.S. if a specified percentage of the fund interests were beneficially owned by U.S. investors.
Potential Exemption for Venture Capital and Private Equity Funds
The Wall Street Reform and Consumer Protection Act contains a
provision that would exempt advisers to Venture Capital Funds while
The Restoring American Financial Stability Act would exempt
advisers to both Venture Capital and Private Equity Funds. However,
neither of the legislative proposals attempts to define the terms
Venture Capital Fund nor Private Equity Fund. Again, the definition
of these terms is left to a future SEC rulemaking proceeding.
In the past, the SEC has found it difficult to develop functional
definitions based on a fund's investment strategy. As such,
fund managers should not assume that the eventual definitions of
Venture Capital Fund and Private Equity Fund adopted by the SEC
would mirror how such funds are typically defined by industry
professionals. It should also be noted that a fund manager who
advises both a venture capital or private equity fund and a hedge
fund would not be permitted to rely on the exemption with regard to
its activities on behalf of the hedge fund.
State Law Regulation
It should also be noted that The Restoring American Financial Stability Act passed by the Senate raises the threshold for firms that are permitted to register with the SEC to $100 million. If this aspect of the Senate proposal becomes law, fund managers, including non-U.S. fund managers, will need to more carefully consider whether they will become subject to regulation under the laws of the various states in which their U.S. investors reside.
Conclusion
Both The Wall Street Reform and Consumer Protection Act and The
Restoring American Financial Stability Act remain legislative
proposals as of the date of this article and neither has yet become
law. Each of the House of Representatives and the Senate have
passed differing versions of the legislation and both versions have
been referred to a House/Senate Conference Committee where
differences between the two proposals, such as the treatment of
Private Equity Funds and the threshold for registration, will be
resolved.
As indicated above, both proposals also require subsequent SEC
rulemaking proceedings to define important terms and phrases such
as the definition of "Venture Capital Fund" and
"attributable to clients in the U.S." These SEC
rulemaking proceedings will have a profound impact on the scope and
application of the new law.
Despite remaining questions about the details of the legislation
and subsequent SEC rulemaking proceedings, it appears almost
certain that the Advisers Act will be amended to delete the current
Private Adviser Exemption and that its application will be expanded
to include non-U.S. fund managers. As such, non-U.S. fund managers
with a significant amount of U.S. investment should carefully
consider whether they might become subject to registration with and
regulation by the SEC. If registration and regulation appear
likely, fund managers should begin planning how they will adapt to
new regulatory requirements applicable to SEC registered Investment
Advisers. Finally, even if a particular fund manager does not meet
the threshold for SEC registration and regulation, additional
consideration will be warranted to determine whether such a fund
manager may be subject to regulation under the laws of the various
states in which its U.S. investors reside.
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.
