United States: Recent Changes in SEC’s Regulation of Investment Advisers

During the past 12 months, the U.S. Securities and Exchange Commission (SEC) has significantly revised its regulation of investment advisers. These regulatory changes and their implications on registered investment advisers, as well as investment advisers to hedge funds who are currently exempt from the registration under the Investment Advisers Act of 1940 (Advisers Act) are highlighted below.

First, we address the rule proposed by the SEC in July 2004, which, if adopted in its present form, will require many investment managers or advisers to unregistered "private funds" (i.e., hedge funds) to register with the SEC1. Second, we discuss the SEC’s final rule published in October 2003 on investment advisers’ custody of client funds or securities2; third, we discuss the rule published in December 2003 under which the SEC now requires that investment advisers adopt compliance programs3; and we finally discuss the final rule dated July 9, 2004 under which investment advisers registered with the SEC must adopt certain codes of ethics4.

(1) Registration Under the Advisers Act of Certain Hedge Fund Advisers

Many investment advisers to hedge funds, private equity funds and other investment funds currently qualify for exemption from registration as an investment adviser under the Advisers Act. The 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 debate5 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 - the Proposed Hedge Fund Rule. Comments to the Proposed Hedge Fund 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. If you are interested in filing comments to the Proposed Hedge Fund Rule, please contact any of the McDermott attorneys listed at the end of this article for assistance.

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 organization to be counted as a single "client."6 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 Hedge Fund 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 Hedge Fund 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 an 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 purposes of this new rule.

The Proposed Hedge Fund 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 Hedge Fund 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; custody of clients’ securities and funds and periodic reporting related thereto; disclosure of regulatory and administrative actions; 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 or have at least $750,000 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 noticeregister 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/s and cannot register with the SEC.

The SEC limited the extra-territorial application of the Proposed Hedge Fund 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 Hedge Fund 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 SEC’s 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 Hedge Fund 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.

(2) Custody of Funds or Securities of Clients by Investment Advisers

Over time the SEC realized that its custody-related no-action letters have started to swallow the rule. In addition, it became obvious that the SEC’s custody rule no longer reflected modern custodial and safekeeping practices. The amendments to Rule 206(4)-2 under the Advisers Act (Custody Rule) modernized the rule by conforming the regulation to such modern practices and required that advisers, which have custody of clients’ funds or securities maintain those assets with "qualified custodians," such as registered broker-dealers, banks, savings associations, registered futures commission merchants and certain foreign financial institutions. Also, the amendments clarified circumstances where the adviser has custody of clients’ assets, by defining the term "custody."

There are two ways clients’ assets must be held with a "qualified custodian": (i) in a separate account for each client under such client’s name; or (ii) in accounts that contain only clients’ funds and securities, but under the investment adviser’s name as agent or trustee for the clients. Note that the new Custody Rule specifically states that "keeping stock certificates in the adviser’s bank safe deposit box would not satisfy the requirements of the rule" and therefore, such adviser will have to open a custodial account with a "qualified custodian" where the contents of the safe deposit box will be recorded with the adviser as an agent or a trustee for the clients.

After ensuring that the assets are held with a "qualified custodian," the adviser must send a notice to its clients describing the custodial arrangement. Next, adviser may choose to either:

  1. send quarterly account statements directly to clients; or
  2. rely on the "qualified custodian" to send these statements (if there is reasonable belief that the "qualified custodian" will send these reports to clients).

If the adviser chooses to send account statements directly to its clients, such adviser must subject itself to surprise audits without prior notice at least once a year and its independent public accountant must file results of the audit with the SEC within 30 days on form ADV-E. The rule also requires independent public accountants to inform the SEC staff (Director of the Office of Compliance Inspections and Examinations) within one business day upon finding any "material discrepancies" in client accounts during the examination.

If the "qualified custodian" sends periodic account statements directly to the clients, the adviser will not be subject to surprise audits even if such adviser has custody of clients’ assets. In either event, the amendments remove the Form ADV requirement that advisers with custody include an audited balance sheet in their disclosure brochure to clients (Form ADV Part II) 7.

There are two exemptions from the reporting requirements concerning clients who are registered investment companies and pooled investment vehicles. With respect to registered investment companies (e.g., mutual funds), advisers must follow more strict reporting requirements under the 1940 Act.

The SEC recognizes that if an investment adviser is also a general partner in a limited partnership, or a managing member of a limited liability company (i.e., a pooled investment vehicle), such adviser will have access to the pooled investment vehicle’s assets. However, if such investment vehicle is annually audited and the financials are sent to the beneficial owners within 120 days of the end of the fiscal year, then the adviser will not be subject to surprise audits. Nonetheless, reports must be sent to all beneficial owners in the pooled investment vehicle on a quarterly basis.

(3) Compliance Programs of Investment Companies and Investment Advisers

In December 2003, following the SEC’s, National Association of Securities Dealers’ (NASD) and state securities authorities’ investigations of abuses in mutual funds trading, the SEC published new Rule 206(4)-7 (the Compliance Rule) that requires investment advisers registered with the SEC to:

  1. adopt and implement written policies and procedures reasonably designed to prevent violation of the federal securities laws;
  2. review those policies and procedures annually for their adequacy and the effectiveness of their implementation; and
  3. designate a chief compliance officer to be responsible for administering these policies and procedures.8

All investment advisers must be in compliance with this new rule by October 5, 2004. In the adopting release, the SEC stated that "the new rules will permit the [SEC] to address the failure of an adviser or fund to have in place adequate compliance controls before the failure has had a chance to harm clients or investors." In other words, failure to implement policies and procedures that ensure compliance with securities laws would be a violation of the securities laws and Section 206(4) of Advisers Act in and of itself.

The purpose of the policies and procedures is to prevent, detect and correct any violations of securities laws. Given that each investment adviser is different, these policies and procedures must be tailored to each investment adviser with regard to possible conflicts and other compliance factors creating risk exposures for the investment adviser and its clients of interest. The SEC requires that at a minimum, these policies and procedures address the following:

  • portfolio management processes;
  • voting of clients’ securities;
  • trading practices to satisfy advisers’ best execution obligations;
  • proprietary trading of advisers and its personnel;
  • prevention of misuse of material non-public information;
  • accuracy of disclosure to clients and regulators;
  • safeguarding assets from misuse by advisers’ personnel;
  • record retaining and maintenance;
  • marketing services, such as the use of solicitors;
  • valuation of clients’ assets;
  • business continuity plans; and
  • additional policies and procedures such as protection of client privacy and anti-money laundering safeguards.

The Compliance Rule does not require all of these policies and procedures to be included in a single document but the investment adviser must have a particular policy and procedure which reasonably addresses these general areas and is tailored to the nature of each firm’s operations.

(4) Investment Adviser Codes of Ethics

In addition to more general policies and procedures, the SEC also issued a new rule 204A-1 effective August 31, 2004 (Code of Ethics Rule), requiring that each investment adviser adopt and implement a written code of ethics for their supervised persons. The code of ethics must set forth investment adviser’s and its employees’ standards of conduct and require compliance with federal securities laws. In addition, the code of ethics must address conflicts that arise from personal trading by advisory personnel and require such personnel to report their personal securities holdings and transactions, including the transactions involving affiliated mutual funds or other investment vehicles, and obtain pre-approval of certain investments from the firm’s chief compliance officer or other designated person. As a result of this new Code of Ethics Rule, investment advisers must establish and maintain a database of all their employees’ reports submitted in connection with reportable trades, as well as reports of possible violations of the code of ethics.

The SEC does not prescribe any particular format for the code of ethics and requires that each firm adopt the code of ethics that is reasonably adapted to the unique nature of each adviser's business operations and reflect the adviser’s fiduciary obligations and those of its supervisory persons and compliance with federal securities laws. Regardless of whether an investment adviser is a one-person operation or a multinational corporation, the code of ethics must set out ideals for ethical conduct premised on fundamental principles of openness, integrity, honesty and trust. Accordingly, the rule also now requires advisers to describe their code of ethics in Form ADV Part II and furnish a copy of the code upon a client’s request.

At a minimum, the SEC requires that the code of ethics address the following:

  • protection and access to material non-public information;
  • advisers’ employees’ personal securities trading, including designation of "restricted lists" of certain reportable securities, designating "access persons" who must report their transactions, filing initial, quarterly and annual securities holding reports;
  • obtaining approvals before employees invest in initial public offerings and private placements;
  • prompt reporting of employees’ violation of federal securities laws and the code of ethics;
  • procedures for educating employees about the codes of ethics and their compliance and reporting obligations;
  • adviser review and enforcement of the code; and
  • recordkeeping procedures with retention of records for at least five years.

Finally, the Code of Ethics Rule requires that the adviser must distribute the code to all of its supervised persons and such persons must acknowledge in writing receipt of the code of ethics and the adviser must familiarize its supervised persons with the code of ethics.

For more information on the subject addressed in this memorandum, contact your usual McDermott Will & Emery attorney or Peter Malyshev


1 See 17 CFR Parts 275 and 279, SEC Release No. IA-2266, Registration Under the Advisers Act of Certain Hedge Fund Advisers, dated July 28, 2004, with comments deadline September 15, 2004 (Proposed Hedge Fund Rule).

2 See 17 CFR Parts 275 and 279, SEC Release No. IA -2176, Custody of Funds or Securities of Clients by Investment Advisers, dated October 1, 2003, effective November 5, 2003, with compliance deadline April 1, 2004 (Custody Rule).

3 See 17 CFR Parts 270, 275 and 279, SEC Release No. IA-2204, Compliance Programs of Investment Companies and Investment Advisers, dated December 24, 2003, effective February 5, 2004, with compliance deadline October 5, 2004 (Compliance Rule).

4 See 17 CFR Parts 270, 275 and 279, SEC Release No. IA-2256, Investment Adviser Codes of Ethics, dated July 9, 2004, effective August 31, 2004, with compliance deadline January 7, 2005 (Codes of Ethics Rule).

5 See Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management – Report of the President’s Working Group on Financial Markets, Apr. 1999; see also Hedge Fund Roundtable, May 14 – 15, 2003; see also Implications of the Growth of Hedge Funds, Staff of the SEC Report, Sept. 2003.

6 Ironically, the Commodity Futures Trading Commission (CFTC) has changed its Commodity Pool Operator (CPO) and Commodity Trading Advisor (CTA) rules in August of 2003 to no longer "look through" investment vehicles for the purpose of similar 15-clients-in-12-months exemption and now generally counts legal entities as single clients.

7 Investment Advisers whose assets under management exceed $25 million are subject to registration with the SEC and must file Form ADV Part 1 electronically. This form provides the adviser’s contact information, as well as basic information on the adviser’s business operations, client base, assets under management, affiliations and related businesses, ownership and control as well as certain regulatory disclosures. Form ADV Part II (brochure) is a suggested form of disclosure document that is not filed with the SEC, but must be sent to all clients prior to entering into an advisory relationship under Rule 204-3 of the Advisers Act. This form requires disclosure of possible situations where an adviser may have conflicts of interest. It is likely that the SEC will soon require that this Form ADV Part II is also filed.

8 Amended Form ADV Part 1, Schedule A, Item 2(a) requires designation of a firm’s single compliance officer.

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.

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