Article by Keith T. Robinson, Karen L. Anderberg, Jennifer O. Wood and Derek B. Newman
The Obama administration presented the U.S. Congress with its far-reaching recommendations to overhaul the U.S. financial regulatory system (the "Plan") on 17 June 2009. Among other things, the Plan calls for the registration of investment advisers to private pools of capital, including hedge funds, private equity funds and venture capital funds, with assets under management above a "modest" amount. On 15 July 2009, the Obama administration delivered to the U.S. Congress the Private Fund Investment Advisers Registration Act of 2009 (the "Private Advisers Bill"), draft legislation that is intended statutorily to implement certain aspects of the Plan.1 In addition, shortly before the Plan was unveiled, Senator Jack Reed introduced into the U.S. Senate the Private Fund Transparency Act of 2009 (the "Private Fund Bill" and, collectively with the Private Advisers Bill, the "Bills").2 These two pieces of legislation generally are consistent and, if either is adopted, would significantly expand the number of investment advisers required to register with the U.S. Securities and Exchange Commission ("SEC"), including non-U.S. investment advisers.
The Plan and the Bills are the latest efforts by U.S. politicians eager to subject private funds and their managers to closer regulatory scrutiny.3
The Obama Administration Plan
The Plan recommends that investment advisers to private pools of capital whose assets under management exceed some "modest threshold" be required to register with the SEC. Although the Plan does not call for the direct registration of funds, the Plan does recommend that investment funds advised by SEC-registered advisers be subject to recordkeeping requirements and disclosure requirements with respect to investors, creditors and counterparties. Presumably, the investment advisers to these funds would be required to ensure that these requirements are met, and the Plan recommends that the SEC conduct regular, periodic examinations of these funds to monitor compliance.
The Plan also recommends that registered investment advisers be required to report to the SEC information on the funds they manage, and that such information should be sufficient to assess whether any fund poses a systemic threat. The SEC would be required to share this information with the U.S. Federal Reserve Board (the "Fed").
Under the Plan, the Fed is charged with supervisory authority over financial firms posing systemic risks, which may include hedge funds, private equity funds and venture capital funds. The Fed would identify such funds based on criteria to be established by the U.S. Congress, which would likely include the fund's "size, leverage and interconnectedness". Funds that pose a systemic risk would be designated as "Tier 1 Financial Holding Companies" ("Tier 1 Funds") and would be subject to strict capital, liquidity and risk management standards. The possible substantive regulation of Tier 1 Funds represents a break from the current trend in U.S. hedge fund and private equity fund regulatory efforts, which to date have focused on disclosure as opposed to substantive regulation.4
The Private Advisers Bill and the Private Fund Bill
Either Bill, if enacted, would amend the U.S. Investment Advisers Act of 1940 (the "Advisers Act") to require: (i) the registration of many investment advisers that have heretofore been able to rely on certain exemptions from SEC registration; and (ii) periodic reporting by advisers of fund-specific information.
Adviser Registration
Under the current U.S. regulatory regime, an "investment adviser" is defined as "any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities." The Advisers Act generally requires that any person so defined register with the SEC, unless the adviser can rely on an exemption from the registration requirement. The most common exemption relied on by advisers to hedge funds, private equity funds and other pooled investment vehicles is Section 203(b)(3) of the Advisers Act (commonly known as the "Private Adviser Exemption"), which currently is available to any adviser that:
- has advised fewer than 15 clients in the course of the preceding 12 months;
- does not hold itself out generally to the public as an investment adviser; and
- does not advise any U.S.-registered investment company or business development company.
Each Bill would amend the Private Adviser Exemption such that a U.S.-based adviser generally would be required to register with the SEC, regardless of the number or type of clients advised, if the adviser has US$30 million of assets under management.5
In addition, the Private Advisers Bill specifically addresses the status of a U.S.-based adviser of a "private fund", which is defined as (i) an investment fund that relies on either of the two exceptions from regulation as an investment company on which hedge funds, private equity funds and venture capital funds generally rely, and (ii) which is either organized or created under the laws of the United States (or any state thereof) or has 10 percent or more of its outstanding interests owned by U.S. persons. The adviser of such a private fund generally would be required to register with the SEC if the adviser has US$30 million of assets under management, and could not rely on the intrastate adviser exemption in Section 203(b)(1) or the commodity trading advisor exemption in Section 203(b)(6), which are two other exemptions from investment adviser registration on which some hedge fund managers rely.6
Application to Non-U.S. Investment Advisers
While generally rescinding the Private Adviser Exemption, each Bill introduces the concept of a "foreign private adviser" ("FPA"), which may continue to rely on a limited exemption from registration. Under each Bill, an FPA is defined as any investment adviser that:
- has no place of business in the United States;
- during the preceding 12 months has had
- fewer than 15 clients in the United States; and
- assets under management attributable to clients in the United States of less than US$25 million; and
- neither holds itself out as an investment adviser generally to the public in the United States, nor acts as an investment adviser to a U.S.-registered investment company.
Therefore, a non-U.S. adviser with only a limited number of U.S. clients generally would be required to register with the SEC only if assets attributable to such clients exceeded US$25 million.
Potential Limits with Respect to U.S. Clients
When counting U.S. clients for purposes of the new FPA exemption, current Rule 203(b)(3)-1 under the Advisers Act (the "Counting Rule") generally would permit, among other things, any FPA to count a U.S. private fund as a single client, rather than each individual investor in such a fund. In addition, FPAs currently would not be required to count non-U.S. funds as clients under the Counting Rule, even if those non-U.S. funds have a significant number of U.S. investors.
However, each Bill explicitly grants the SEC authority to redefine "client" for purposes of the Counting Rule. In light of prior SEC efforts to expand hedge fund adviser registration, it is possible that the SEC would adopt amendments to the Counting Rule with the effect that FPAs will be required to "look through" funds and count U.S. investors in a fund as clients of the adviser for purposes of determining compliance with the 15 U.S. client limit.7 If the SEC were to adopt such amendments, FPAs may be required to strictly limit the actual number of U.S. investors in their funds (and the amount of their investments) in order to rely on the FPA exemption contemplated in either Bill. However, the Private Advisers Bill appears to be primarily intended to require the registration of investment advisers to "private funds" (i.e., U.S. funds or non-U.S. funds with a significant U.S. client base). Accordingly, while their ultimate treatment remains unclear if the Private Advisers Bill becomes law in its current form, non-U.S. advisers to non-U.S. funds may be able to avoid investment adviser registration in the U.S. by strictly limiting the level of investment by U.S. clients, or they may be able to rely on the commodity trading advisor exemption in Section 203(b)(6) of the Advisers Act.8
In addition to the potential change of status of U.S. investors in a fund, each Bill also would effect another major change with respect to the current terms of the Private Adviser Exemption by imposing the requirement that an FPA must source less than US$25 million from U.S. clients. No such asset limitation currently exists, and non-U.S. advisers may have to register with the SEC as a result of a single significant U.S. private client or U.S. investor if either Bill is enacted as proposed.
Effect of Registration on Non-U.S. Advisers
Presumably, non-U.S. advisers required to register with the SEC under either Bill would be permitted to rely on existing guidance excepting registered non-U.S. advisers from certain provisions of, or rules under, the Advisers Act with respect to non-U.S. clients. However, registered non-U.S. advisers must comply with the substantive provisions of the Advisers Act with respect to the firm's U.S. clients.
Registration under the Advisers Act imposes a number of requirements that could significantly impact adviser operations and compliance costs. In addition to registering with the SEC and meeting various disclosure obligations, registered advisers generally are required to, among other things, comply with extensive recording-keeping requirements and maintain a compliance program reasonably designed to prevent violations of the Advisers Act. Registered advisers are also subject to the SEC's adviser inspection program, which is designed to ensure that the adviser is in compliance with the Advisers Act and other U.S. federal securities laws, and that the adviser's business activities are consistent with its disclosure.
Periodic Reporting of Fund-Specific Information
Each Bill also attempts to implement the Plan's recommendations with respect to periodically reporting fund-specific information. Each Bill would require U.S.-registered advisers to submit such reports as are necessary or appropriate for the evaluation of systemic risk posed by funds managed by the adviser. The disclosure requirements of the Private Advisers Bill are more detailed, and specify that an adviser disclose assets under management (including off-balance sheet leverage), counterparty credit risk exposures, trading and investment positions and trading practices with respect to each private fund managed by the adviser. Under the Private Fund Bill, these reports also would include information about funds sponsored by the adviser or its affiliates, or funds for which the adviser or its affiliates act as underwriter, distributor, placement agent or finder. Currently, U.S.-registered advisers are not required to disclose information about their clients.
In order to alleviate concerns over confidentiality, each Bill makes clear that the SEC is not required to publicly disclose information reported by advisers with respect to the funds they manage. In addition, each Bill limits the availability of this information pursuant to requests under the U.S. Freedom of Information Act. However, the SEC would be permitted to share this information with Congress, other Federal departments or agencies or self-regulatory organisations.
In addition, the Private Advisers Bill (but not the Private Fund Bill) authorises the SEC to adopt rules requiring that private fund advisers provide designated reports, records and other documents to investors, prospects, counterparties and creditors. However, the Private Advisers Bill does not detail the types of information that private fund advisers may be required to disclose with respect to the funds that they manage.
Conclusion
The Private Fund Bill has been submitted for consideration to the Senate Committee on Banking, Housing and Urban Affairs. To date, no action has been taken with respect to the Private Advisers Bill. Given that each Bill appears to reflect the suggestions of the Plan, either Bill may gain more momentum in the U.S. Congress than the legislation that was previously introduced. However, it is difficult to predict at this time whether or when either Bill will be debated or passed, or the content of any final legislation.
Notwithstanding the uncertain future of the Bills, managers of U.S. and non-U.S. funds should carefully monitor the progress of the Bills or any other effort to implement the Plan, and consider the potential impact of the same on the operations of their businesses, funds and investors. It is important to note that each Bill's fund-specific reporting requirement would go beyond the scope of the current disclosure obligations associated with SEC investment adviser registration. If such a disclosure obligation is ultimately enacted, advisers may want to revisit their funds' offering documents and management agreements. In addition, an investment adviser may wish to consider the appropriateness of disclosing in its funds' offering materials that the adviser may be required to disclose to the SEC and other regulators certain information about the funds. Even though the Plan and each Bill contemplates that this information should be provided to regulators on a confidential basis, current fund investors (especially non-U.S. investors) that are concerned about confidentiality may be concerned regarding any type of regulatory disclosure obligation.
Footnotes
1 The Private Advisers Bill is available at http://www.treasury.gov/press/releases/reports/title%20iv%20reg%20advisers%20priv%20funds%207%2015%2009%20fnl.pdf.
2 The Private Fund Bill is available at http://thomas.loc.gov/cgi-bin/query/z?c111:S.1276:.
3 In addition to the above, the Hedge Fund Adviser Registration Act of 2009 (the "Capuano Bill") was introduced into the U.S. House of Representatives in January and, if enacted, would also require the registration of many advisers to funds that currently are able to rely on an exemption from registration. In addition to the registration of investment advisers, U.S. politicians have also targeted the funds managed by such investment advisers for registration. The Hedge Fund Transparency Act of 2009 (the "Grassley Bill") was introduced into the U.S. Senate in January and, if enacted, would require the registration of all private pools of capital with US$50 million or more in assets under management. For a more detailed discussion of the Capuano Bill, please refer to the February 2009 DechertOnPoint dated at http://www.dechert.com/library/FS_6_02-09_Proposed_Legislation_Would_Require_Every_Investment_Adviser.pdf. For a more detailed discussion of the Grassley Bill, please refer to the February 2009 DechertOnPoint at http://www.dechert.com/library/FS-02-05-2009-2-1.pdf.
4 However, in 15 July 2009 testimony before the U.S. Congress in support of the Private Fund Bill, the director of the SEC's Division of Investment Management suggested that substantive regulation of such funds through registration with the SEC or through expanded SEC rulemaking authority was a possible alternative to regulation of unregistered fund advisers.
5 In many instances, a U.S. adviser may elect to register with the SEC if it has at least US$25 million of assets under management.
6 The "intrastate adviser exemption" in Section 203(b)(1) of the Advisers Act exempts from the requirement to register under the Advisers Act any investment adviser all of whose clients are located in the same state within which the adviser maintains it principal place of business. The "commodity trading advisor exemption" in Section 203(b)(6) of the Advisers Act exempts from the requirement to register under the Advisers Act any investment adviser registered with the Commodity Futures Trading Commission as a commodity trading advisor (i) whose business does not consist primarily of acting as an investment adviser (as defined in Section 202(a)(11) of the Advisers Act) and (ii) who does not act as an adviser to a U.S.-registered investment company or business development company.
7 In 2004, the SEC adopted amendments to the Counting Rule and added a companion rule under Section 203(b)(3) (together, the "2004 Rule"), which required investment advisers to look through certain funds and count investors in the fund as clients of the adviser for the purposes of determining compliance with the Private Adviser Exemption. However, the 2004 Rule was subsequently vacated by the U.S. Court of Appeals for the District of Columbia. See Goldstein et al. v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006).
8 Section 203(b)(6) of the Advisers Act provides that an investment adviser registered with the Commodity Futures Trading Commission as a commodity trading advisor, whose business does not consist primarily of acting as an investment adviser (as defined in Section 202(a)(11) of the Advisers Act) and who does not act as an adviser to a U.S.-registered investment company or business development company, is exempt from registration under the Advisers Act.
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