United States: SEC Proposals for Offshore Advisers

EXECUTIVE SUMMARY

Effective July 21, 2011, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) eliminates the exemption from federal investment adviser registration that is currently available to advisers with fewer than 15 clients. In the past a large number of offshore advisers have relied on this exemption and, accordingly, are not currently registered with the SEC.

In place of this exemption, Dodd-Frank includes several new exemptions, including an exemption for foreign private advisers (Offshore Exemption), an exemption for advisers solely to venture capital funds (Venture Capital Exemption) and an exemption for advisers solely to private funds with assets under management (AUM) in the US of less than $150 million (150 Million Exemption).

On November 19, 2010, the SEC issued two releases proposing how these new exemptions would work, as well as covering several other matters. See Release Nos. IA-3110 and IA-3111.

The new regulatory structure contemplated by the SEC would result in very significant changes for advisers and managers of private funds who have their principal place of business outside the US. In many cases, offshore advisers who were previously exempt from the US investment adviser registration provisions will need to register as investment advisers in the US. In addition, many exempt advisers will become subject to reporting requirements with respect to the pooled investment vehicles that they manage.

This article summarizes the provisions of these releases relating to the Offshore Exemption, the Venture Capital Exemption and the 150 Million Exemption from the point of view of an offshore adviser that is not currently registered as an investment adviser in the US.

OVERVIEW OF THE SEC PROPOSALS

The Offshore Exemption

Dodd-Frank contains a new exemption from Federal investment adviser registration for foreign private advisers. Advisers need to fall within the following criteria to qualify as foreign private advisers:

• have no place of business in the US;
• have less than $25 million in AUM with respect to US clients or investors in private funds;
• have less than 15 clients and investors in private funds in the US; and
• do not hold themselves out generally to the public in the US as an investment adviser.

The SEC is proposing a "uniform" method of calculating AUM for these advisers (and for several other purposes), which involves the use of fair value (rather than cost) and includes uncalled capital commitments.

The Venture Capital Exemption

Dodd-Frank contains an exemption for advisers that only manage venture capital funds, and directs the SEC to define a venture capital fund. The SEC has proposed that an adviser managing only funds meeting certain requirements would be eligible for the Venture Capital Exemption. Funds satisfying these requirements would be "venture capital funds" under the proposed rule. The requirements are:

• the fund invests in equity securities of qualifying private companies (explained below) to provide operating and business expansion capital;
• at least 80% of the securities of each company owned by the fund need to be acquired by the fund directly from the portfolio company, rather than from investors in the portfolio company;
• the fund directly or through its advisers controls or offers or provides significant managerial assistance to each qualifying portfolio company;
• the fund does not borrow or otherwise rely on leverage (other than limited short term borrowing); and
• the fund does not offer its investors redemption or other similar liquidity rights, except in extraordinary circumstances.

In addition, a venture capital fund needs to represent itself to be a venture capital fund (rather than a hedge fund, private equity fund or multi-strategy fund) and cannot be registered under the Investment Company Act of 1940, as amended (ICA), or be a business development company (BDC).

The proposed rule includes a grandfather clause under which existing funds that do not meet all these requirements can still qualify as venture capital funds if they have represented themselves as venture capital funds, accepted outside investments before the end of 2010 and accept no new investments after July 21, 2011.

An adviser can manage an unlimited number of venture capital funds with unlimited AUM under this exemption.

An offshore adviser may rely on the proposed exemption if all of its clients, US or offshore, are venture capital funds.

The 150 Million Exemption

The SEC has also proposed the terms of a new 150 Million Exemption. An offshore adviser can manage any number of US private funds under this exemption, so long as the only US advisory clients are private funds and the aggregate AUM managed from a place of business in the US is less than $150 million.

For this purpose, a private fund is an investment vehicle that is exempt from registration under the ICA pursuant to either the C1 exemption (less than 100 beneficial owners) or the C7 exemption (a qualified purchaser fund). An offshore adviser cannot provide investment advice to any US clients other than private funds. If an offshore adviser has even one US advisory client that is not a private fund, including any managed account or individual client, it would not qualify for this exemption regardless of the amount of AUM. The determination of who is a US client is made in a manner consistent with Regulation S.

AUM will need to be calculated quarterly and if AUM increases above $150 million, this exemption will no longer be available. In this case, an adviser will have three months to register, if the adviser has complied with its reporting requirements. An offshore adviser needs to count private fund assets it manages from a place of business in the US.

Reporting Requirements for These Exempt Advisers

Dodd-Frank provides that the SEC can require advisers who are exempt from Federal investment adviser registration under either the Venture Capital or the 150 Million Exemption to file reports. The SEC's proposal includes the form, content and manner of filing of these reports. These reports are proposed to be contained in a portion of Form ADV, and would be filed electronically on the system currently used by registered investment advisers. As a result, the information in those reports will be publicly available.

The required material includes data about the adviser and extensive information about funds managed. The first report would need to be filed by August 20, 2011.

These reporting provisions do not apply to advisers who qualify for the Offshore Exemption.

CURRENT STATUS OF THE SEC PROPOSALS

The comment period on these proposals has ended. The SEC received a large number of comments, and is in the process of reviewing the comments. We expect that the SEC will issue final rules in the April-May time frame.

ACTION ITEMS

Between now and the issuance of final rules, you should prepare for the coming regulatory changes. Consider the following actions:

√ Offshore Exemption – You should determine if you have any US clients or investors, and determine the number of those US clients and investors. If that number is less than 15, you should determine if you have a "place of business" in the US, and if so, determine the amount of AUM managed from that place of business.

√ Venture Capital Exemption – If you manage an existing venture capital fund, you should determine if this fund qualifies under the grandfather clause. You should also determine if it is feasible going forward for your new funds to operate as venture capital funds under the proposed rule.

√ 150 Million Exemption – You should determine if your AUM is less than $150 million as calculated in accordance with the proposed rule, and if each of your US advisory clients will qualify as a private fund.

√ New Reporting Obligations – If you will qualify under either the new Venture Capital Exemption or the new 150 Million Exemption, you should prepare to comply with the exempt advisers reporting requirements. These requirements will involve disclosing extensive information about private funds managed as explained below.

√ Restructuring of Operations – If you do not currently qualify for the new Offshore Exemption, the Venture Capital Exemption or the new 150 Million Exemption, you may wish to consider the possibility of restructuring your operations so that you do qualify.

√ Registration – If you do not qualify for these exemptions, and no other exemptions are available, you should determine if you are eligible for federal registration and begin preparing for registration.

Currently, foreign advisers that register with the SEC generally need to comply with the substantive provisions of the Advisers Act only with respect to US advisory clients. We expect that the SEC will continue this approach under the new regulatory structure. Accordingly, an offshore adviser generally would not treat US investors in offshore feeder funds as US clients because the fund itself is not a US client (and the investors in the feeder are not clients), but would need to treat stand-alone funds and feeder funds as US clients if the funds are organized under US law.

It is not clear how offshore advisers with US registered affiliates will be handled. The SEC previously has dealt with this issue under the principles set forth in a series of no action letters known as the Unibanco line of no action letters. The SEC has stated that whether an offshore adviser would be required to register will be determined on a facts and circumstances basis. It is possible that the SEC will provide further guidance on this issue in the adopting releases.

√ State Regulatory Issues – The proposed Offshore, Venture Capital and 150 Million Exemptions do not provide exemptions for state purposes. Accordingly, advisers will need to check applicable state law and monitor state law for changes in response to Dodd-Frank.

We anticipate that a number of states will revise their investment adviser provisions in response to the new regulatory structure resulting from Dodd-Frank. The North American Securities Administrators Association (NASAA) has already proposed a model rule in response to the exemptions discussed in this article. The proposed NASAA Model Rule would provide a state exemption for C7 funds where the adviser does not have a "disqualifying" regulatory history, and files the report described above with the state as well as with the SEC. The comment period for this rule has also ended. Of course, each state would make its own decision about whether to adopt the proposed NASAA Model Rule.

DETAILS ON OFFSHORE EXEMPTION

The SEC's proposal includes the specific criteria for a "foreign private adviser" to qualify for the new Offshore Exemption.

No Place of Business in the US –

The SEC defines a place of business as an office at which the investment adviser regularly provides investment advisory services, meets with, or otherwise communicates with clients, and any other location that is generally held out to the general public as a location at which these activities take place.

Usually the existence or non-existence of a place of business in the US is relatively clear. In some cases, a "place of business" in the US can exist because of activities in the US that might not ordinarily be considered to be an office in the traditional sense. An offshore adviser seeking to use this exemption should make sure that its US activities are consistent with the SEC's interpretation of the meaning of "place of business".

Less than 15 Clients and Investors in Private Funds in the US –

The number of clients is proposed to be determined in a manner very similar to the current method for determining compliance with the "less than 15" clients rule. For a natural person the following are counted as one client:

• the person's minor children, whether or not they share the same home " any relative, spouse or relative of the spouse, who shares the same principal residence
• any account of which any of the persons identified in the last two bullets is the main beneficiary
• all trusts of which any of the persons identified in the first two bullets are the main beneficiaries

An entity which is advised based on the investment objectives of the entity is treated as one client. Entities that have the same owners are treated as the same client.

Clients for which an adviser does not receive compensation are required to be counted. In addition, private funds that have investors that are counted under the separate investor test will not need to be counted.

In addition to US clients, US investors in funds also will count against the 15 limit. The SEC's proposal concerning investor status is generally based on the same analysis that is currently used to determine the number of beneficial owners of a C1 fund, and in the case of a C7 fund, whether the outstanding securities in the fund are all owned by qualified purchasers.

Several adjustments and clarifications to the current provisions are proposed. Knowledgeable employees would be included, as well as any owner of outstanding short-term paper. Investors in a feeder fund formed for the purpose of investing in a master fund would be required to be counted.

Any person holding an interest through a nominee arrangement or total return swap would also be counted.

The determination of who is a US person will generally be made in a manner that is consistent with existing Regulation S.

Calculation of AUM

The SEC is proposing changes to Form ADV which are intended to provide a "uniform" method for calculating AUM for this purpose and for other regulatory purposes. This method is based on the value (rather than cost) of assets managed, as well as proprietary assets, assets managed without compensation and uncalled capital commitments. Liabilities cannot be deducted. If the governing documents of the fund provide for a method of determining fair value, that method can be used, so long as it is consistent with the requirements of the proposed rule. The proposing release does not provide guidance on the valuation of illiquid investments, and does not require that fair value be determined in accordance with GAAP.

Holding Out

A foreign private adviser cannot hold itself out to the public as an investment adviser in the U.S.

The SEC's interpretation of what constitutes holding out is broad. An offshore adviser intending to use this exemption should make sure that its operations are conducted in a manner that is consistent with the SEC's interpretation of the holding out concept.

Offshore Exemption Issues

The proposed rule is fairly narrow and is not likely to be widely applicable because the AUM limit is low.

In addition, determining US investors in private funds could present significant practical issues.

DETAILS ON VENTURE CAPITAL EXEMPTION

The Venture Capital Exemption will be available to advisers that only manage "venture capital funds." The SEC proposes to define a venture capital fund as a company that invests in equity securities of qualifying portfolio companies (QPCs) and cash or cash equivalents and US Treasuries with a remaining maturity of 60 days or less. For this purpose, an equity security is contrasted with a debt security, which is not a qualifying investment, unless convertible into equity.

An offshore adviser can rely on this exemption if all of its clients, US and offshore, are venture capital funds.

Qualifying Portfolio Company

A QPC is any company that:

• Is not publicly traded. At the time of each investment by the fund, the QPC needs to be a private company and cannot be controlled by a public company. A venture capital fund may continue to own securities of a QPC that goes public after the investment by the fund.
• Does not incur leverage in connection with investment by the fund. Any financing or loan to a portfolio company provided by or as a condition of a contractual obligation with a fund or the adviser to a fund would be considered to be "in connection with" an investment by the fund. This provision does not restrict borrowing by the QPC from other sources.
• Uses the investment by the fund for operating or expansion purposes. Capital provided by a venture capital fund cannot be used to buy out existing investors or be distributed to existing investors. As a result, the investment of a venture capital fund cannot be used to redeem existing investors or to fund payments to existing investors in a recapitalization. The proposed rule does provide a limited ability to buy out investors in a QPC, in that up to 20% of a venture capital fund's position in a QPC can be the result of purchases from existing investors in the QPC.
• Is an operating company as opposed to an investment vehicle. This requirement prohibits investment in a fund or securitized asset vehicle.

An offshore company can be a QPC. In other words, in order to be a QPC, the entity does not need to be a domestic company or doing business in the US.

Management Assistance

A venture capital fund (directly or through its adviser) needs to either control the QPC or have an arrangement to provide management assistance to the QPC.

The proposing release states that managerial assistance would generally take the form of active involvement in the business, operations or management of the portfolio company, or less active forms of control such as board representation, or similar voting rights.

Each venture capital fund participating in an investment needs to satisfy this requirement. It is not clear how this requirement will work as a practical matter in the case of an investment in the same QPC by several venture capital funds.

Limited Buy-outs

At least 80% of the securities of each QPC need to be purchased directly from the QPC. Put another way, up to 20% of the securities of a QPC can be purchased from investors in the QPC. The SEC stated that this provision was intended to allow a venture capital fund to provide liquidity to the founder of a QPC or an angel investor.

Limitation on Leverage

A venture capital fund cannot incur debt, issue guarantees or otherwise use leverage in excess of 15 % of capital and uncalled capital commitments, and any borrowing, guarantee or leverage needs to be for a non-renewable term of no more than 120 days. This 15% limit is calculated on an aggregate basis and not deal by deal.

Limited Redemption Rights

Interests in a venture capital fund cannot be redeemable at the option of the holder except in extraordinary circumstances, which the SEC expects generally to be beyond the control of the investor, such as a change in law.

Represents Itself to be a Venture Capital Fund

A venture capital fund needs to represent to investors and potential investors that it is a venture capital fund, as opposed to a hedge fund, private equity fund or multi-strategy fund. A venture capital fund can satisfy this requirement by describing its investment strategy as venture capital investing or as a fund that is managed in compliance with the SEC's proposed rule.

Not a Mutual Fund or BDC

A venture capital fund cannot be registered under the ICA or be a BDC.

Venture Capital Exemption Issues

The proposed rule contains a narrow definition of a venture capital fund. This definition generally will exclude advisers to private equity funds. As a result, advisers to those funds will either need to qualify for another exemption or register (if eligible). An offshore adviser that does not have a place of business in the US would usually be subject to federal registration, if no exemptions apply. An offshore adviser that has a place of business in the US would also need to consider state law and the division of registration responsibility between state and federal regulators. (In general, Federal registration is required if the adviser has $100 million or more of AUM, and otherwise state registration is required. There are a few situations where Federal registration is required for an adviser with less than $100 million, such as where the adviser is not subject to state registration and examination requirements or would be required to register in 15 or more states.)

In addition, there are a number of practical issues with the proposed venture capital fund rule.

Some of these issues only impact offshore advisers. For example, the offshore venture capital investment structure may not always fit the business model that forms the basis for the Venture Capital Exemption. Also, in order to rely on the Venture Capital Exemption, all clients, both US and offshore, need to be venture capital funds, even if there are no US investors in those funds.

Some of the criteria present practical issues in a general sense. Only private companies will qualify as QPCs. As a result, the proposal does not allow investments in PIPES. And, of course, an investment immediately before an initial public offering could cause a problem under the proposed definition.

A venture capital fund can hold equity securities of QPCs. A venture capital fund cannot hold debt securities of a QPC unless those securities are convertible to equity. This aspect of the proposal is particularly restrictive in terms of bridge financings.

Follow on investments are subject to the same restrictions.

The SEC's proposal requires that funds invested by a venture capital fund in a QPC be used for operations or expansion, rather than to buy out investors in the QPC. This requirement could cause ambiguity concerning the ability of a QPC to buy out investors in a QPC after an infusion of capital from a venture capital fund. Establishing that funds for redemptions did not come from a cash infusion might be difficult as a practical matter.

The proposing release is very clear that a fund of funds structure will not qualify under the Venture Capital Exemption. However, the proposing release does not explicitly indicate whether certain unconventional fund structures (such as fund structures where individual investors can opt out of specific investments) will qualify.

Also, there is some ambiguity concerning exactly what will be considered to be "management assistance", as required by the rule.

Grandfather Provision

The proposed rule includes a grandfather clause that allows certain existing funds to be considered to be venture capital funds even if they do not meet all the criteria outlined above so long as the following criteria are satisfied:

• the fund represented that it was a venture capital fund to investors and potential investors at the time the fund offered its securities;
• the fund sold securities to one or more outside investors before December 31, 2010; and
• the fund does not sell any securities, including accepting additional capital commitments, from any person after July 21, 2011.

Under the SEC's proposal, funds representing that they are hedge funds or private equity funds would not qualify under this provision.

An adviser that only advises venture capital funds meeting the proposed definition could also advise venture capital funds that fit under the grandfather provision.

DETAILS ON 150 MILLION EXEMPTION

Dodd-Frank directs the SEC to adopt an exemption from the Federal adviser registration provisions for any investment adviser solely to private funds that in the aggregate have less than $150 million in AUM in the US.

Advises Solely Private Funds

This new exemption will be available to an adviser that only manages private funds.

For this purpose, private fund means a C1 (less than 100 beneficial owners) or a C7 (qualified purchaser fund). An offshore adviser cannot provide advice to any US client other than a private fund. The determination of who is a US client is proposed to be made in a manner consistent with Regulation S. If an offshore adviser has even one US client that is not a private fund, that adviser will not qualify for this exemption. Also, an offshore adviser can manage any number of US private funds, so long as the aggregate AUM managed from a place of business in the US is less than $150 million.

Calculation of AUM

Under the proposed rule, an offshore adviser would need to aggregate the value of all assets of private funds it manages from a place of business in the US to determine if the adviser is under the $150 million threshold.

This calculation would need to be done on a quarterly basis in the manner described above.

A sub-adviser would only need to count that portion of the assets of the private fund as to which it has responsibility.

Transition Rule

The SEC is proposing that an adviser that becomes ineligible to use the 150 Million Exemption because of an increase in AUM will have three (3) months to register. This grace period will only be available if the adviser is in compliance with its reporting obligations.

150 Million Exemption Issues

While the new definition of AUM is intended to be uniform, it does not provide any guidance in the area of valuation of illiquid investment positions. A portion of, and in many cases a substantial portion of, private fund investments can be expected to be in illiquid securities. Significant variation in the approach to the valuation of these securities may take place after implementation begins.

In addition, the method of determining AUM for an offshore adviser as proposed appears to be inconsistent with the method of determining permissible clients. AUM is based on clients advised from a place of business in the US. Whether the offshore adviser satisfies the "solely to private funds" requirements is based on all US clients.

EXEMPT REPORTING ADVISER

Advisers qualifying for the new Venture Capital Exemption or the new 150 Million Exemption will need to file reports concerning the funds they manage. These reports will need to be made on a specified portion of Form ADV, and filed on the system currently used by registered advisers. These reports would need to be filed electronically and there will be a fee associated with the filing. In addition, the information contained in these reports will be publicly available.

The information required to be reported includes information about the adviser, as well as the private funds managed.

Adviser Information. The information required with respect to the adviser includes the following:

• Name, contact information, form of organization and ownership of the adviser (including identification of owners)
• Other activities of the adviser or its affiliates that might cause conflicts of interest
• Disciplinary history of the adviser

Fund Information. The report will also need to contain comprehensive information about the private funds managed including the following:

• identifying information
• organizational information
• master or feeder
• fund of funds
• ICA exemption
• 33 Act exemption
• gross and net asset values
• investment strategy, type of fund
• breakdown of assets and liabilities under the GAAP (Level 1, 2 and 3) classification system
• fund investors – number and type
• minimum investment amount
• characteristics of the fund that may give rise to conflicts of interest in terms of the fiduciary duty of the adviser
• identification and information concerning 5 service providers
• • Auditor – whether it is independent, registered with and inspected by the PCAOB and distributes audited statements to investors
  • prime broker – whether it is SEC registered and acts as custodian for fund assets
  • custodians – whether they are related persons of the adviser
  • administrator – whether it prepares account statements and sends them to investors and what percentage of fund assets it values
  • marketers – whether they are related persons of the adviser, their SEC file number and the address of any web site they use to market the fund

The SEC is proposing that a coding system can be used to avoid identifying the private fund by name. However, service providers will need to be named.

An exempt reporting adviser needs to provide the information specified as to funds it manages, but not as to funds managed by its affiliates.

Timing and Updating. The first report will need to be filed by August 20, 2011. This information will need to be updated on an annual basis, and amended more frequently in certain circumstances.

SEC EXAMINATIONS

Exempt reporting advisers are subject to examination by the SEC. An examination might be triggered by information contained in the new required filings, or as a result of other examinations or developments.

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.