The Private Fund Investment Advisers Registration Act of 2010 (the Act), signed into law on July 21, markedly changes who will be required, and who will be permitted, to register as investment advisers with the Securities and Exchange Commission (SEC). The Act, which is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank), also provides various new exemptions and mandates numerous studies. This Client Advisory summarizes some of the central provisions of the Act:
- Elimination of small/private adviser exemption, resulting in required registration for many private fund managers
- $100 million threshold for SEC registration of advisers managing accounts and private funds
- Permissive SEC registration for certain multi-state advisers with $25 million to $100 million of assets
- Exemption to be adopted for advisers managing only private funds with less than $150 million under management in the United States
- Exemption for "foreign private advisers"
- Various other exemptions—advisers to venture capital funds, family offices, SBICs and CTAs
- Changes to client/investor standards
- Recordkeeping and reporting requirements
- Mandate for studies
Because Congress vested significant discretion in the SEC to
promulgate rules to implement the Act, its full impact will not be
known for some time. In a departure from previous process, the SEC
is now seeking public comment on regulatory initiatives mandated by
Dodd-Frank prior to issuing rule proposals. Comments may be
submitted through topic-specific mailboxes on the SEC website at http://www.sec.gov/spotlight/regreformcomments.shtml.
The following is a synopsis of the main provisions of the Act
and certain issues raised that remain to be addressed through
rulemaking.
Elimination of Small/Private Adviser Exemption
The Act eliminates the exemption from registration under Section
203(b)(3) of the Investment Advisers Act of 1940, as amended, (the
Advisers Act) for investment advisers who (i) have had fewer than
15 clients in the preceding 12 months; (ii) do not generally hold
themselves out to the public as investment advisers; and (iii) do
not act as advisers to registered investment companies or business
development companies. The repeal of this exemption affects many
hedge fund, private equity fund and real estate managers, leaving
them without the exemption on which they have previously relied to
avoid registration as investment advisers. Many fund managers,
including certain foreign advisers with U.S. clients, may be
required to register for the first time.
It is unclear what the effect of the legislation on state law
will be, or how some state laws will apply. Many states have a
registration exemption linked to the repealed Advisers Act Section
203(b)(3). Those states that have such laws must address this or
risk creating a gap in the registration of investment advisers not
qualified to be federally registered and not currently required to
be state registered.
The repeal of Section 203(b)(3) is effective July 21, 2011, and
those advisers newly subject to Advisers Act registration must be
registered by then. The SEC has recently adopted sweeping changes
to Part 2 of Form ADV, the "brochure" required of
investment advisers, which will be required to be filed
electronically. These changes, which will be addressed in a
separate Client Advisory, are effective for new advisers
registering after January 1, 2011. It would be prudent for new
registrants to await the new form to avoid duplicate efforts, even
if they intend to register prior to the effective date of the
legislation.
Definition of Private Fund
The primary focus of the Act is to regulate managers to
"private funds." The Act defines a "private
fund" as an issuer that would be an investment company, as
defined in Section 3 of the Investment Company Act of 1940 (the
ICA), but for the exclusion in Section 3(c)(1) or 3(c)(7) of the
ICA. This encompasses most hedge funds and private equity funds
that are either located in the United States or that are located
offshore but accept subscriptions from U.S. investors.
$100 Million Threshold for Advisers Managing Accounts and
Private Funds
The Act raises the threshold of assets under management required
for SEC registration to $100 million. Investment advisers currently
registered with the SEC that have assets under management between
$25 million and $100 million that will be subject to registration
in and examination by the state in which they have their principal
places of business will be required to de-register and become
regulated by the states. The impact on advisers in states such as
New York that do not have examination programs is unclear at this
time.
Permissive Registration for Multi-State Advisers with Assets Under Management of between $25 Million and $100 Million
SEC registration would be available to an adviser with assets between the $25 million and $100 million levels if that adviser would be required to register in 15 or more states. This is more permissive than the SEC's current rule permitting multi-state advisers to register with the SEC if they would have to register in 30 or more states.
Intra-state Advisers
The Act eliminates the exemption from registration under Section 203(b)(1) for an intra-state adviser that manages a private fund, although the exemption is still available to other intra-state advisers.
Exemption for Advisers Managing Only Private Funds with Less than $150 Million under Management in the United States
The Act directs the SEC to adopt rules providing an exemption
from registration for an adviser that solely manages private funds
and has less than $150 million in assets under management in the
United States. Such exempted advisers would still be required to
maintain certain records and provide reports to the SEC.
The SEC is also directed to provide registration and examination
procedures for advisers to "mid-sized private funds,"
which term is not defined in the Act, taking into account the size,
governance and investment strategy of such funds to assess the
systemic risk they pose.
Foreign Private Adviser Exemption
Even non-U.S.-based advisers could be required to register if they
have U.S. clients and meet the asset threshold, although as
discussed below, there may be questions as to the SEC's ability
to assert jurisdiction over foreign advisers with a limited nexus
to the United States. Presuming that registration would be
required, the Act provides a limited exemption from such
registration for a "foreign private adviser" that
satisfies all of the following requirements: The advisor (1) has no
place of business in the United States; (2) has, in total, fewer
than 15 U.S. clients and U.S. investors in "private
funds" advised by the adviser; (3) has aggregate assets under
management attributable to U.S. clients and U.S. investors in
"private funds" advised by the adviser of less than $25
million (or such higher amount as the SEC may deem appropriate);
and (4) neither (i) holds itself out generally to the U.S. public
as an investment adviser, nor (ii) acts as an investment adviser to
any registered investment company or business development
company.
There remain legal questions, however, about the reach of SEC
jurisdiction to require registration of a non-U.S.-based adviser
with no direct clients, even if U.S. persons invest in non-U.S.
funds they manage. Under the decision of a federal court of appeals
in Goldstein v. SEC, a fund, and not an investor in a
fund, is the client of the foreign adviser for U.S. definitional
purposes. Therefore, absent contacts directed into the United
States that might confer jurisdiction, a foreign adviser who
advises only offshore funds and other clients outside the United
States would not fall under the Advisers Act at all. The inclusion
in the exemption for foreign private advisers of thresholds for
U.S. investors in private funds creates uncertainty as to the
applicability of the Act to such advisers. The definition also
creates uncertainty as to the continued applicability of prior SEC
guidance to international financial institutions under no action
letters such as Uniao Banco de Brasileiros S.A. and its
progeny that allowed such institutions to provide services to U.S.
persons through a registered investment adviser without subjecting
their non-U.S. operations to SEC registration and oversight.
Various Other Exemptions
Venture Capital Fund Adviser Exemption. The Act
provides an exemption from registration for advisers solely to
"venture capital funds," with that term to be defined by
the SEC by July 21, 2011. Although exempt from registration, these
advisers will be required to maintain records and provide to the
SEC such annual or other reports as the SEC determines.
Exclusion for Family Offices. The Act excludes
"family offices" from the definition of "investment
adviser" and thus from Advisers Act registration. It again
leaves the term to be defined by the SEC by July 21, 2011, but
directs that the rules defining "family office" be
consistent with previous SEC exemptive orders and certain
grandfathering provisions. The SEC has previously issued exemptive
orders to family offices serving the lineal descendants of a single
individual, their spouses and entities, including private
foundations and charities exclusively owned by or for the benefit
of, or created by, such individuals. On a few occasions, the SEC
has permitted exempted family offices to allow key executives and
employees involved in investment decisions to participate in the
family's collective investment vehicles on a limited
basis.
Small Business Investment Company Exemption. The
Act exempts from Advisers Act registration any investment adviser
that solely advises small business investment companies that are
licensees under the Small Business Investment Act of 1958 (other
than business development companies regulated under the ICA). These
investment advisers, however, are not required to maintain records
and provide reports to the SEC.
Commodity Trading Advisor (CTA) Exemption. The Act
maintains the exemption from Advisers Act registration for any
investment adviser that is registered with the Commodity Futures
Trading Commission (CFTC) under the Commodity Exchange Act, as
amended (the CEA) as a CTA whose business does not consist
primarily of acting as an investment adviser as defined in the
Advisers Act, but adds that, if the business of the adviser should
become "predominately the provision of securities-related
advice," then such adviser must register as an investment
adviser with the SEC.
Client Eligibility
Adjustments to Accredited Investor Standards. The
Act modifies immediately the net worth threshold for individual
"accredited investors" and also directs the SEC to review
and adjust all "accredited investor" standards in Rule
501 of Regulation D under the Securities Act of 1933, as
follows:
- The net worth threshold for individuals will remain $1 million until July 21, 2014, but now excludes the value of the individual's primary residence. The SEC has already clarified that any mortgage on the primary residence may be excluded from calculation as well, except that any amount of mortgage in excess of the fair market value of the residence must be treated as a liability and deducted from net worth.
- The SEC is authorized immediately to review the definition of the term "accredited investor" for natural persons and to promulgate rules adjusting the provisions of the definition that do not relate to the net worth threshold.
- The SEC is required to review the definition of the term "accredited investor" in its entirety as applied to natural persons every four years and to modify the definition as appropriate "for the protection of investors, in the public interest, and in light of the economy."
Adjustments to "Qualified Client"
Standard. The Act requires the SEC to adjust for the
effect of inflation every five years the dollar amount standards
used to determine client eligibility to pay performance fees.
Standard of Conduct for Brokers Providing Personalized
Advice. The Act authorizes the SEC to promulgate rules
providing that the standard of conduct for brokers, dealers and
investment advisers that give personalized investment advice about
securities to retail customers, and other customers as provided by
SEC rules, shall be "to act in the best interest of the
customer without regard to the financial or other interest of the
broker, dealer or investment adviser providing the advice."
The Act further provides, however, that any material conflict of
interest must be disclosed to and may be consented to by the
customer. For these purposes, a "retail customer" is a
natural person who receives personalized investment advice and uses
that advice for personal, family or household purposes. The SEC is
also directed to facilitate the provision of simple and clear
disclosures to investors regarding their relationships with
brokers, dealers and investment advisers, including material
conflicts of interest, and to promulgate rules prohibiting sales
practices, conflicts of interest and compensation schemes for
brokers, dealers and investment advisers that it deems contrary to
the public interest and the protection of investors. This
rulemaking authorization is significant, as it represents a change
from purely disclosure-based regulation toward a public interest
standard, irrespective of meaningful disclosure and informed
consent.
The Act also provides for the SEC to conduct a study of these
issues in conjunction with its rulemaking. On July 27, the SEC
requested public comment for such a study to evaluate the
effectiveness of existing legal or regulatory standards of care in
connection with personalized advice to retail customers and asked
whether there are gaps, shortcomings or overlaps in legal or
regulatory standards. See: http://www.sec.gov/rules/other/2010/34-62577.pdf.
Recordkeeping and Reports
Private Fund Records and Reports. The Act requires
registered advisers to private funds to maintain records and file
reports containing specified information regarding such funds,
including: (i) the amount of assets under management and use of
leverage (including off-balance sheet leverage); (ii) counterparty
credit risk exposure; (iii) trading and investment positions; (iv)
valuation policies and practices of the fund; (v) types of assets
held; (vi) side arrangements or side letters; (vii) trading
practices; and (vii) other information determined to be necessary
in the public interest, for the protection of investors or for the
assessment of systemic risk. There are provisions requiring
confidential treatment of such records and reports. The SEC is
required to inspect the records of private funds maintained by an
investment adviser, and must provide an annual report to Congress
describing how the SEC has used the data collected to monitor the
markets for the protection of investors and the integrity of the
markets.
Protection of Advisers' Proprietary
Information. The Act enhances confidentiality protection
with respect to proprietary information provided by investment
advisers to the federal government by making information provided
under the Act to the SEC not subject to the Freedom of Information
Act and providing additional safeguards. The Act defines
"proprietary information" to include sensitive,
non-public information regarding: (i) the investment or trading
strategies of the investment adviser; (ii) analytical or research
methodologies; (iii) trading data; (iv) computer hardware or
software containing intellectual property; and (v) any additional
information that the SEC determines to be proprietary.
Client Information. The Act adds a further
exception to the general rule that client information is
confidential, which would enable the SEC to require the disclosure
by SEC-registered investment advisers of certain client information
"for purposes of assessment of potential systemic risk,"
as well as in connection with enforcement proceedings and
investigations.
Other Significant Provisions
Extraterritorial Application. The Act adds a new
provision to the Advisers Act on extraterritorial jurisdiction,
giving the U.S. courts jurisdiction over certain conduct occurring
outside the United States, but only in a case brought under the
antifraud provisions in Section 206 involving such conduct that has
a "foreseeable substantial effect" in the United States.
The U.S. courts also have antifraud jurisdiction over conduct
within the United States that constitutes "significant steps
in furtherance of a violation" even if the violation is
committed by a foreign adviser and involves only foreign investors.
The Act is silent on extraterritorial application of the
registration provisions of the Advisers Act.
Custody of Client Assets. The Act allows the SEC
to promulgate rules to require registered advisers to take steps to
safeguard client assets over which they have custody, including
requiring verification of such assets by an independent public
accountant. This is legislative underpinning for actions taken by
the SEC in amending the custody rule earlier this year.
Definition of "Client." The Act
prohibits the SEC from modifying the definition of the term
"client" for purposes of Section 206(1) and 206(2) of the
Advisers Act, which prohibit fraud against clients and prospective
clients, to include investors in a private fund managed by an
investment adviser, if such fund has entered into an advisory
contract with such adviser. It does not circumscribe the definition
of "client" under SEC rules adopted pursuant to Section
203 of the Advisers Act, the registration requirement. The
legislation does not overrule the Goldstein decision,
which held that a private fund, rather than each investor, is the
"client."
Rule of Construction Relating to the Commodity Exchange
Act. The Act states that nothing in the Advisers Act shall
relieve any person of any obligation or duty, or affect the
availability of any right or remedy available to the CFTC or any
private party arising under the CEA governing commodity pools,
commodity pool operators or commodity trading advisors.
Advisers Registered with the CFTC. The Act
requires the SEC and the CFTC, after consultation with the
Financial Stability Oversight Council, jointly to promulgate by
July 21, 2011, rules to establish the form and content of reports
to be filed with the SEC under Section 204(b) of the Advisers Act
and with the CFTC by advisers registered both under the Act and the
CEA.
Authority to Restrict Mandatory Arbitration. The
Act authorizes the SEC to prohibit or impose limitations on the use
of agreements that require "customers or clients" of any
investment adviser to arbitrate any future dispute arising under
the federal securities laws, rules thereunder or the rules of a
self-regulatory organization.
Studies
The Act requires the Comptroller General or the SEC to conduct a
number of studies and report to the Senate Committee on Banking,
Housing, and Urban Affairs and the House Committee on Financial
Services within three years (unless otherwise specified).
Study and Report on Accredited Investors. The Act
requires the Comptroller General to conduct a 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.
Study on Custody Rule Costs. The Act requires the
Comptroller General to conduct a study of the compliance costs
associated with compliance with and recordkeeping related to
Advisers Act custody requirements, and specifically the additional
costs if subsection (b)(6) of Rule 206(4)-2 relating to operational
independence were eliminated.
Study on Self-Regulatory Organization for Private
Funds. The Act requires the Comptroller General to conduct
a study about the feasibility of forming a self-regulatory
organization to oversee private funds and report on the results by
July 21, 2011.
Study and Report on Short Selling. The SEC
Division of Risk, Strategy, and Financial Innovation ("Risk
Fin") is required to conduct a study, taking into account
current scholarship, on the state of short selling on national
securities exchanges and over-the-counter markets, with a focus on
the impact of recent rule changes and the incidence of (i) the
failure to deliver shares sold short, or (ii) delivery of shares on
the fourth day following the short sale transaction. Risk Fin must
submit a report on the results of the study, including
recommendations for market improvements, by July 21, 2012.
Study on Reporting of Short Sales. Risk Fin is
also directed to conduct a study and report the results by July
21,2011, of the feasibility, benefits and costs of (i) requiring
reporting publicly, in real time, short sale positions of publicly
listed securities, or reporting such short positions in real time
only to the SEC and the Financial Industry Regulatory Authority,
and (ii) conducting a voluntary pilot program in which public
companies agree to have all trades of their shares marked
"short," "market maker short," "buy,"
"buy-to-cover" or "long" and reported in real
time through Consolidated Tape.
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