On December 2, 2009, the House of Representatives (the "House") moved one step closer to requiring investment advisers (a term which includes fund managers) to hedge funds and private equity funds to register as investment advisers pursuant to the Investment Advisers Act of 1940, as amended (the "Advisers Act"). Specifically, House Financial Services Committee (the "FSC") Chairman Barney Frank (D-MA) introduced to the House for debate a draft of The Wall Street Reform and Consumer Protection Act of 2009 (the "Wall Street Reform Act"). Included within the Wall Street Reform Act is the Private Fund Investment Advisers Registration Act of 2009 (the "PFIARA"). The Wall Street Reform Act will be submitted to the House Rules Committee on December 8, 2009 and will be debated on the House floor on December 9, 2009 as a single bill.
The PFIARA, which was originally introduced to the FSC on October 1, 2009 by Representative Paul Kanjorski (D-PA), was subject to a mark-up and subsequently approved 67-1 by the FSC on October 27, 2009. The PFIARA is similar to the Restoring American Financial Stability Act of 2009, which was introduced to the Senate by Senate Banking Committee Chairman Christopher Dodd (D-CT) on November 10, 2009 (the "Dodd Bill"). The Dodd Bill is still subject to a mark-up and a final vote from the Senate.
Federal Registration Requirement
Currently, many advisers to private investment funds (including advisers or managers based outside of the United States) rely upon the private adviser exemption to avoid registering as an investment adviser with the Securities and Exchange Commission ("SEC") under the Advisers Act. In general, the private adviser exemption provides that an adviser with less than 15 clients that does not hold itself out to the public is exempt from registration under the Advisers Act. The PFIARA would eliminate the private adviser exemption by removing Section 203(b)(3) of the Advisers Act in its entirety. Consequently, most investment advisers with a requisite amount of assets under management who serve as advisers to domestic or offshore private investment funds, institutional clients, managed accounts, or high net worth individuals, among other types of clients, would be required to register with the SEC regardless of the number of clients to whom the advisers provide advisory services.
Rules And Regulations To Be Based On Systemic Risk Profile
The PFIARA contains a provision that requires the SEC to take certain characteristics of "private funds" (as defined below) into account when prescribing rules and regulations pertaining to registration and examination procedures. While it is not clear at this point how the SEC will address this requirement, the rules and regulations it drafts must address systemic risk presented by private funds. Specifically, the SEC must take into account the size, governance, and investment strategies of "mid-sized funds" (this term is not defined in the PFIARA) to determine whether they pose systemic risk, and tailor the registration and examination procedures applicable to their advisers accordingly.
Exemptions From Federal Registration Requirement
- Advisers To Venture Capital Funds: The PFIARA would exempt advisers to "venture capital funds" from the requirement to register, but has tasked the SEC with defining the term "venture capital fund" and crafting the exemption.1 We anticipate that, in addition to the "foreign private advisers" exemption discussed below, this exemption will also be available to non-U.S. managers and advisers.
- Foreign Private Advisers: The PFIARA would exempt from registration under the Advisers Act "foreign private advisers," defined as investment advisers that (i) have no place of business in the U.S., (ii) do not generally hold themselves out to the public in the U.S., (iii) have fewer than 15 clients in the U.S., and (iv) have less than $25 million in assets under management that are attributable to U.S. clients. As a result, non-U.S. advisers will need to have limited involvement with U.S. clients to avoid registering.
- Advisers With Assets Under Management Of Less Than $150,000,000: Under the PFIARA, investment advisers with less than $150,000,000 in assets under management would not be subject to registration as an investment adviser with the SEC.2 Such investment advisers may be required to register with one or more state securities regulators and will be required to maintain certain records and provide annual and other reports that the SEC determines to be necessary and appropriate for the protection of investors.
Recordkeeping, Reporting And Examinations
The PFIARA would require investment advisers to "private funds" to file certain information including, for each private fund, the assets under management, the use of leverage, counterparty credit risk exposure, valuation methodologies of the fund, and trading and investment positions, among other things. The PFIARA defines a "private fund" as a fund that "would be deemed an "investment company" under the Investment Company Act of 1940 (the "1940 Act"), but for the exceptions in Section 3(c) (1) or Section 3(c) (7) of the 1940 Act.
The PFIARA would also provide the SEC with broad authority to require investment advisers to maintain records and to submit reports to the SEC to enable the SEC or another federal department or agency to supervise systemic risk. The SEC would be required to consult with the Board of Governors of the Federal Reserve System (the "Board") when determining what records an investment adviser to a private fund is required to maintain and the reports they are required to file.
The PFIARA would provide the SEC with broad authority to examine the records of both private funds and the advisers to such funds. The SEC could also request that advisers make available to the SEC copies or extracts of such records.
The SEC would be required to share with the Board or any other federal agency having systemic risk responsibilities, copies of all reports, documents, records and information filed with the SEC. The SEC would keep such information confidential and, subject to certain limited exceptions, could not be compelled to disclose it. Finally, the PFIARA would authorize the SEC to require advisers to private funds to provide to investors, prospective investors, counterparties and creditors such information as the SEC deems necessary or appropriate in the public interest.
Potential Changes To The Definition Of "Client"
Under the current interpretation of the Advisers Act, the term "client" includes only persons or entities that have a direct advisory relationship with the adviser. In the case of a private investment fund, the fund itself would be considered to be the client of the adviser, but the underlying investors in the fund would not be clients. The PFIARA formally adopts this interpretation and prohibits the SEC from including the underlying investors of a private investment fund in the definition of client so long as such fund has entered into an advisory agreement with the adviser.
The Dodd Bill, however, provides the SEC with broad authority to define the term client. If the Dodd Bill were to be adopted in its current form, the SEC could potentially define "client" to include the underlying investors in a private investment fund, which would have a significant impact on a registered adviser with respect to its fiduciary duties to clients, the cash solicitation rule (Rule 206(4)-3), and the custody rule (Rule 206(4)-2). Such a change in definition could also have a drastic impact on the ability of non-U.S. investment managers to claim the benefit of the "foreign private adviser" exemption.
Qualified Client Standard
The PFIARA provides for an inflation adjustment for the "qualified client" standard for purposes of the Advisers Act prohibition on incentive fees set forth in Section 205(a)(1). This inflation adjustment must be made no later than one year after the PFIARA is signed into law and every 5 years thereafter.
Transition Period
The PFIARA provides for a one year transition period from the date of enactment of the bill before the amendments to the Advisers Act become effective. As a result, unregistered advisers to pooled investment vehicles would not have to register with the SEC until 1 year after the PFIARA's enactment.
Please contact Chris Salter at (202) 383-5371 if you would like to discuss the registration process and the various obligations you will be required to comply with once registered.
The attorneys in O'Melveny's global Investment Funds, Securitization, and Investment Adviser Regulation and Compliance practices are actively engaged in the key areas of law affecting investment funds, including corporate law, partnership law, tax, ERISA and U.S. and non-U.S. securities laws.
Footnotes
1. The Dodd Bill contains an exemption from registration for advisers to private equity funds in addition to venture capital funds.
2. The Dodd Bill contains a similar exemption from registration for advisers with assets under management of less than $100,000,000.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
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