United States: SEC Proposes Hedge Fund Adviser Registration Rule

On July 20, 2004, the U.S. Securities and Exchange Commission (the "SEC") proposed new and amended rules and forms (the "Proposal") that would require advisers to certain private investment pools ("hedge funds") to register with the SEC under the Investment Advisers Act of 1940 (the "Advisers Act").¹

As a result of the recent substantial growth and popularity of hedge funds, the staff of the SEC in September 2003 issued a comprehensive study entitled "Implications of the Growth of Hedge Funds" recommending that advisers to hedge funds be required to register with the SEC as investment advisers under the Advisers Act. On July 20, 2004, the Commission by a three to two margin voted for the Proposal, which if adopted would require certain investment advisers to hedge funds that are not already registered under the Advisers Act to register with the SEC.

The Advisers Act exempts from registration any investment adviser, other than an investment adviser to a registered investment company, who during the course of the preceding 12 months has had fewer than 15 clients and who does not hold itself out generally to the public as an investment adviser. SEC rules adopted in 1985 state that an investment adviser that provides investment advice to an organization based upon its investment objectives rather than the investment objectives of its individual owners may treat the organization as one client for purposes of the 15 client rule.

Under the Proposal, an investment adviser to a private investment company that is a "private fund" will be required to look through the private investment company and count the owners of that private investment company as clients for purposes of determining if the investment adviser has 15 or more clients, which might require it to be registered under the Advisers Act. A private investment company is a "private fund" if it meets three conditions: (1) the company is exempt from registration as an investment company under either of the two private investment company exemptions contained in the Investment Company Act of 1940 (i.e., either it has fewer than 100 securityholders or its securityholders are "qualified purchasers" as defined in the 1940 Act and it does not make or propose to make in a public offering of its securities), (2) the company permits its owners to redeem any portion of their ownership interests within two years of the purchase of such interests, and (3) interests in the company have been offered based on the investment advisory skills or expertise of the investment adviser. To the extent that interests are redeemable by reason of events that the company, after reasonable inquiry, finds are extraordinary and unforeseen (such as the death of an investor), such interests are not deemed to be redeemable for purposes of the "private fund" definition.

If a hedge fund meets the definition of a "private fund," there is a look-through to its shareholders, limited partners, members, other securityholders, or beneficiaries to determine if the investment adviser has more than 15 clients. If an investment adviser provides advisory services to a private fund in which an investment company registered under the Investment Company Act of 1940 is an owner, the investment adviser must count the owners of that registered investment company as its clients for purposes of determining if it meets the 15-client test. If the investment adviser has its principal place of business in the United States, all clients are counted. If the investment adviser has its principal place of business outside the United States, only clients resident in the United States are counted for purposes of the 15-client rule.

The SEC staff made it clear in the Proposal that private equity funds, venture capital funds, and other similar funds that require investors to make long-term commitments of capital should not be viewed as offering "redeemable" interests. Whether an investor’s right to redeem its interest before the end of the second anniversary of its commitment for regulatory or other reasons fits within the "extraordinary and unforeseen" event exception remains to be clarified in the final regulations.

If the investment adviser and the hedge fund have their principal offices or places of business outside the United States, the investment adviser may treat the hedge fund as its client for all purposes of the Advisers Act, except for the 15-client rule, but if the hedge fund meets the definition of a "private fund," it must count all U.S. "equity owners" as clients for purposes of the 15-client rule. However, the anti-fraud provisions of the Advisers Act would apply to such non-U.S. investment advisers.

Under the Proposal, any investment adviser that, prior to the adoption of the Proposal entitled, was to receive a performance fee from investors that were not "qualifying clients" as defined in regulations promulgated under the Advisers Act would continue to be entitled to receive such compensation, but only with respect to equity investors that did not meet the requirements of being "qualified clients" prior to the effective date of the Proposal.

If a hedge fund has its principal office and place of business outside the U.S., makes a public offering of its securities outside the U.S., and is regulated as a public investment company under the laws of a country other than the United States, it will not be deemed to be a private fund for purposes of the Proposal. Thus, investment advisers to publicly offered non-U.S. regulated investment companies will not be required to register under the Advisers Act.

Investment advisers that are required to be registered will be subject to increased regulatory burdens. They will, for example, be required to comply with the various regulatory obligations under the Advisers Act, such as maintaining books and records as required, providing appropriate disclosure to clients, complying with the rules regarding custody of client assets, establishing the proxy voting policies and procedures, adopting written compliance policies and procedures and appointing a chief compliance officer to supervise such policies and procedures, adopting a code of ethics, as well as complying with other substantial transactional provisions of the Advisers Act, such as the requirement to obtain client consent for principal and agency transactions.

There has been significant criticism of the Proposal from certain hedge fund industry groups and representatives of hedge fund advisers, as well as strong dissent about the Proposal from two of the five SEC commissioners, charging that the Proposal will not prevent any of the recent scandals involving the hedge fund industry and will only add unnecessary and costly regulatory burdens to the hedge fund industry. There is, however, strong momentum for adoption of the Proposal, as well as regulatory environment that is fostering such adoption.