United States: Changes Imposed On Missouri Asset Managers By Dodd-Frank

Republished with permission of the Bar Association of Metropolitan St. Louis and The St. Louis Bar Journal.

The scope of changes impacting investment advisers and broker-dealers wrought by the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd- Frank") is significant and growing as various government agencies act to implement the law. This article highlights those changes, with a focus on investment advisers (both those who are and who are not presently required to register) whose primary operations are based in Missouri.

Investment Adviser Categories

Generally

Persons meeting the definition of "investment adviser"¹ under the Investment Advisers Act of 1940, as amended ("Advisers Act") must register as such,² unless they are exempted under §203(b) or prohibited from registration under §203A. Section 203A was added to the Advisers Act in 1996 as part of the National Securities Markets Improvement Act of 1996 ("NSMIA") in a broader effort to divide federal and state responsibilities over securities activities.³ Because most state laws define "investment adviser" in a manner similar to the way the term is defined in the Advisers Act, if an adviser is prohibited from registering under the Advisers Act because of §203A, they often will be required to register in one or more states. Section 222 of the Advisers Act limits the extent to which a state may regulate an adviser as such unless the adviser has a place of business and six or more clients in the preceding 12 months in the state.

"Smaller Advisers"

Advisers Act §203A(a)(1) provides that an adviser which is regulated or required to be regulated as an investment adviser in the state of its principal office and place of business may not register under §203, unless the adviser has assets under management ("AUM") of at least $25 million or advises an investment company registered under the Investment Company Act of 1940 (the "1940 Act"). Advisers with less than $25 million of AUM are sometimes referred to as "smaller advisers," and this provision was not changed by Dodd-Frank. Notwithstanding this prohibition, the SEC has, via rule, determined that certain smaller advisers may still register under the Advisers Act.⁴

"Mid-Sized Advisers"

Section 410 of Dodd-Frank added a new category of investment adviser to §203A of the Advisers Act -- the "mid-sized adviser." These are advisers which are required to be registered as investment advisers with the state where they maintain their principal office and place of business, and, if so registered, would be subject to examination as an adviser by the state securities authority, and have AUM between $25 and $100 million. Mid-sized advisers may not register under the Advisers Act unless they advise an investment company registered under the 1940 Act ("RIC") or a company that has elected to be treated as a business development company ("BDC") under the 1940 Act, or if they would otherwise be required to register with 15 or more states. These changes to the Advisers Act take effect on July 21, 2011.

Depending on the final versions of various rule amendments proposed by the SEC, U.S.-based advisers with less than $100 million of AUM will generally not be able to register federally, unless they

Registration of Venture & Private Fund Advisers

Another significant change imposed by Dodd-Frank is the requirement that managers of private funds and venture capital funds register as investment advisers under the Advisers Act. Dodd-Frank §403 -- again, effective July 21, 2011 -- will eliminate the so-called "15 client exemption" relied upon by private fund and venture capital fund managers in the past. That provision exempted most managers of venture capital funds and private funds⁵ from registration, so long has they had fewer than 15 clients, did not hold themselves out as investment advisers, and did not advise RICs or BDCs. Under Advisers Act §203(l) (added by Dodd-Frank §403) and proposed implementing Rule 203(l)-1,⁶ an adviser which solely advises one or more venture capital funds⁷ will generally not have to register under the Advisers Act, regardless of the number of funds advised or their value. Under Advisers Act §203(m) (added by Dodd-Frank §403) and proposed implementing Rule 203(m)-1,⁸ an adviser which solely advises one or more private funds will generally not have to register under the Advisers Act, provided their AUM in the United States does not exceed $150 million.

Larger Advisers

Even though their registration status will not change as a result of Dodd-Frank, investment advisers with over $100 million in AUM may face considerable changes as a result of Dodd-Frank, depending on their business activities. Some of those changes are already in effect, while the rulemaking process for others has just begun.

Form ADV

Part I of Form ADV is the form investment advisers must file with the SEC (and states if they are so registered) to register as such and update regularly, and such information is publicly available on the SEC's website. Part II of Form ADV is used to inform clients and potential clients about the adviser's business, and beginning in 2011 will be publicly available for SEC-registered advisers. The SEC has proposed to require all advisers, even if their AUM is well over $100 million, to update Part I of their Form ADV by August 20, 2011 to confirm their AUM.⁹

In an effort to better understand the risk profiles of its registered advisers (and therefore improve the allocation of its examination resources), recently proposed SEC amendments expand the scope of information that advisers must report on Form ADV.¹⁰ First, both advisers that are exempt under the new venture and private fund adviser exemptions and The St. Louis Bar Journal/SPRING 2011 39 registered advisers (see additional discussion below) will be required to provide extensive information about each private or venture fund managed by the adviser. Second, registered advisers must include additional information about the scope of their business, including the types of services they provide and types of clients they provide the services to under the amended Form ADV. Such additional information would include, for example, the amount of regulatory AUM attributable to each type of client the adviser has, and whether clients are foreign. Third, both registered and unregistered advisers that manage private or venture funds will have to publicly disclose on Form ADV expanded information about the adviser's industry affiliations and the financial services provided by the adviser. This requirement is designed, in part, to determine if affiliates that provide financial services must also be registered. Finally, the SEC has proposed expanding the information registered advisers must provide concerning their custodial arrangements, disciplinary events, referral arrangements, and soft dollars.

AUM Calculation

Because Dodd-Frank focuses on AUM as a measurement to assess systemic risks, among other reasons, the SEC has proposed¹¹ to eliminate advisers' ability to opt in or out of SEC registration through omitting certain assets in their AUM calculation. Proposed ADV instructions would require an adviser to include in their AUM all securities portfolios for which the adviser provides continuous and regular supervisory or management services, regardless of whether the assets are proprietary, managed without compensation or managed for a foreign client. Further, the SEC proposal will no longer allow advisers to subtract debt and other accrued but unpaid liabilities in client accounts from their AUM.

Rules recently proposed by the SEC would also require advisers to include the value of any private fund managed by the adviser in its AUM calculation -- regardless of the type of assets held by the private fund. The SEC further proposed to require private fund advisers to count the value of any uncalled capital commitments to private funds they manage in their AUM, among other changes.

Whistleblower Rules

Dodd-Frank added new §21F to the Securities Exchange Act of 1934 ("Exchange Act"), which established a regulatory framework under which the SEC may pay a cash reward to eligible whistleblowers who voluntarily provide the SEC with certain information about a violation of the federal securities laws. In November 2010, the SEC proposed rules to implement this provision of Dodd- Frank.¹² Generally, those rules would provide that individuals may receive between 10% - 30% of any monetary sanction of at least $1 million obtained by the SEC in a federal court or administrative proceeding. There are numerous conditions proposed respecting such rewards, and the proposal has garnered extensive commentary.

Adjustments to Financial Qualifications

Numerous rules under which advisers may operate contain conditions based upon investor standards. For example, advisers may sponsor and brokers may sell private or venture funds and utilize the Rule 506 exemption from the registration requirement of the Securities Act of 1933. Dodd-Frank §413 altered the accredited investor standard on July 21, 2010 by providing that an investor's net worth may not include the value of one's primary residence, and requires periodic adjustments based upon inflation. The SEC has proposed amending Rule 501 to conform to such change.¹³ Advisers Act-specific financial standards must also be adjusted periodically under Dodd-Frank §418, including client net worth-based exemptions from the prohibition on the receipt of advisory fees based upon capital gains (contained in Advisers Act §205(a)).

Recordkeeping & Reporting

The SEC has proposed that both registered and unregistered advisers of venture and private funds be required to publicly file Form ADV which would contain information about the funds they manage.¹⁴ The SEC has also proposed implementing Dodd-Frank §404, which amended Advisers Act §204(b), to require registered investment advisers to maintain and file on Form PF extensive records respecting the private funds they manage.¹⁵

Affiliations

Dodd-Frank §619, commonly referred to as the "Volcker Rule," will impact registered advisers and brokers that are affiliated with certain banks and bank holding companies. That provision prohibits proprietary trading and the organization or offering of private funds by such affiliates. Numerous exemptions, as well as rulemaking by the SEC, the Federal Reserve and others, may materially affect the scope of these restrictions.

Other Changes

While not exhaustive, the following are other changes imposed by Dodd-Frank that may impact Missouri- based asset managers:

Smaller & Mid-Sized Advisers

As discussed above, if an investment adviser has less than $100 million of AUM and does not advise an RIC, they likely will have to register in one or more states and switch from federal registration after July 2011.

Under Advisers Act §222, states may regulate investment advisers, so long as they have a place of business and six or more clients in the preceding 12 months in that state, though states may not increase recordkeeping or bonding requirements beyond the requirements of the home state in which an adviser is registered. This means that small and mid-sized advisers with offices in multiple states may have to contend with multiple sets of advisory statutes and rules.

Generally speaking, because dealing with multiple state laws can be onerous, and because advisers can find more predictability with federal advisory regulation, many advisers would prefer to register with the SEC rather than register with one or more states. Furthermore, SEC-registered advisers may not relish the obligation to now switch to state registration as a result of Dodd-Frank.

The "Switch"

The SEC recently proposed²² Rule 203A-5 under the Advisers Act which, if adopted, will require all ad- The St. Louis Bar Journal/SPRING 2011 41 visers registered with the SEC as of July 21, 2011 to update their AUM on their Form ADV by August 20, 2011. Under the rule, if an adviser is no longer eligible for SEC registration at that time, the adviser will need to de-register with the SEC by October 19, 2011. Under applicable state law, such advisers will generally need to be registered by such date. States have been and continue to work with the North American Securities Administrators Association ("NASAA") to coordinate the migration of an estimated 4,000-4,100 investment advisers from federal to state registration. The Missouri Securities Division ("MSD") indicates it is participating in such coordination and estimates between 60 and 80 advisers that are presently registered with the SEC will need to switch to registration with Missouri - a 30% increase.

What Missouri-Based Advisers Should Expect

The Missouri Securities Act of 2003 ("MSA"), which is based on the Uniform Securities Act of 2002 promulgated by the National Conference of Commissioners on Uniform State Laws ("NCCUSL"), is in many ways consistent with the Advisers Act and the SEC and courts' implementation of it by design.²³ Because of this similarity and the experience of the MSD's staff, Missouri-based advisers may find that switching from SEC registration will not be as problematic as feared.

Comparison of Laws

The following chart summarizes the similarities and differences between the Advisers Act and the MSA and their respective rules. It is a high-level summary and not intended to be exhaustive. After the topic, the middle column lists the Advisers Act/rule provision with its citation in parenthesis, and the right column first notes whether there is a change under the MSA/rule from the federal provision, and then the MSA/rule provision with citation.

Examinations & Enforcement

Clients facing a switch from federal to Missouri adviser regulation may wonder how enforcement of the MSA differs from the Advisers Act, and whether the MSD approaches examinations differently than the SEC. As noted above, although an estimated 4,000 to 4,100 federally registered advisers are expected to switch to state registration in 2011, the MSD expects 60 - 80 will be required to switch to Missouri registration. Thus, unlike some state regulatory authorities facing extreme budget difficulties combined with a dramatic increase in duties, the MSD anticipates being capable of fulfilling its regulatory oversight responsibilities respecting investment advisers when Dodd-Frank is implemented.

One way in which the MSD limits the amount of auditors' time required for on-site examinations is by devoting more time to internally reviewing the adviser. Unlike the SEC, the MSD invests resources and time reviewing much more about an adviser before it is registered as such. Once registered, the MSD's internal review focus is similar to the risk-based approach the SEC has migrated to over the past year -- both agencies review materials filed or provided by registrants and prioritize on-site visits based upon these reviews. Advisers that manage private funds, have custody of client assets, have a large diversity of type of client, or provide advice on complicated matters typically present more risks in regulators' eyes, and therefore should expect to be examined more by both agencies. In addition to examinations based on the level of risk, both the SEC and the MSD will conduct examinations "for cause," e.g., resulting from a tip or complaint.

Whereas previously a federallyregistered adviser could expect an examination once every five years,²⁴ the SEC has more recently attempted to focus its examination resources on firms that present the most risk. Prior to the implementation of Dodd- Frank, a Missouri-registered adviser could expect to be examined once every three years, though the amount of time between examinations could increase with the increased number of registrants at the state level.

Generally speaking, the examination process in Missouri is not much different than for SEC-registered advisers. Both the MSD and the SEC will usually provide the registrant with a notice of an impending examination, along with a request for documents (some of which must be provided before the examination and others that must be readily available during the examination). Depending on the size of an adviser's operations and complexity, several examiners may spend up to several days in the registrant's office. Typically with both agencies, the registrant will receive a letter detailing any deficiencies discovered in the examination.

Depending on the severity of the deficiency, the registrant may simply need to inform the agency of how it corrected the deficiency, or the registrant may need to provide documented proof of the correction, or, in more serious cases, face a follow-up visit or even a referral to the agency's enforcement division.

Conclusion

Whether an investment adviser based in Missouri needs to make "the switch" or not, they very well may need to conform their compliance programs and/or operations to a myriad of changes resulting from the passage and implementation of Dodd-Frank. Similarly, counsel for these advisers will need to carefully track the changes discussed above as well as many forthcoming changes in order to appropriately advise their asset management clients.

Footnotes

^{1. Advisers Act §202(a)(11) defines an "investment adviser" 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, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities . . . ." "Investment adviser" does not include banks, professionals such as lawyers whose performance of such services is incidental to the practice of their profession, brokers or dealers whose performance of such services are incidental to their business as such and who do not receive special compensation, publishers of specified media, persons who provide advice only on certain government securities, ratings organizations (subject to exceptions), and others designated by the Securities and Exchange Commission ("SEC"). Effective July 21, 2011, "family offices," as further defined via rule by the SEC, will also be excluded from the definition of "investment adviser." See Dodd-Frank §409.}

^{2. Advisers Act §203(a).}

^{3. See §303(a) of the Investment Advisers Supervision Coordination Act, October 11, 1996 (part of NSMIA).}

^{4. Those persons include nationally recognized statistical rating organizations ("NRSROs"), certain pension consultants, advisers controlled by, controlling, or under common control with other registered advisers, advisers expecting to be eligible for SEC registration within 120 days, advisers which would be required to register with 30 or more states (except if the adviser is required to register with fewer than 25 states, then it must withdraw from SEC registration), and internet advisers. See Rule 203A-2. The SEC recently proposed amending this rule as part of its Dodd-Frank implementation by eliminating the NRSRO exclusion, increasing the AUM requirement for pension advisers from $50 to $200 million, and (consistent with Dodd-Frank §410) excluding advisers that would be required to register in 15 or more states from §203A's prohibition. In its release, the SEC requested comment regarding whether these exclusions should apply to both small and mid-sized advisers. See Release No. IA-3110, December 10, 2010 ("Release 3110").}

^{5. Generally speaking, and as defined by Dodd-Frank §402(a), "private funds" refer to issuers of securities that otherwise meet the definition of an investment company under the 1940 Act, but for the exemption found in §§3(c)(1) or 3(c)(7). "3(c)(1) funds" are funds which generally have no more than 100 owners, "3(c)(7) funds" are funds which are entirely owned by "qualified purchasers," and neither such fund may make or propose to make a public offering of its securities.}

^{6. See Release No. IA-3111, December 10, 2010 ("Release 3111").}

^{7. Defined in Release 3111 as private funds which (1) invest in equity securities of private companies in order to provide operating and business expansion capital with at least 80 % of each such company's securities owned by the fund that are acquired directly from the company; (2) directly, or through investment advisers, offer or provide significant managerial assistance to, or control, each portfolio company; (3) do not borrow or otherwise incur leverage; (4) do not regularly offer investors redemption or other similar liquidity rights; (5) represent themselves as a venture capital fund to investors; and, (6) are not registered under the 1940 Act or a BDC.}

^{8. See Release 3110.}

^{9. Id.}

^{10. Id.}

^{11. See Release 3110.}

^{12. Release No. 34-63237, November 17, 2010.}

^{13. Release No. IA-3144 (January 25, 2011).}

^{14. See Release 3110. Private and venture fund advisers exempt from registration would have to file less information than required of registered advisers under the proposal.}

^{15. Release No. IA-3145 (January 26, 2011).}

^{16. See Release No. IA-3098, October 18, 2010.}

^{17. Release No. 34-63727, January 21, 2011; Release No. 34-63557, December 30, 2010; Release No. 34-63556, December 21, 2010; Release No. 34-63452, December 21, 2010; Release No. 34-63347, December 10, 2010; Release No. 34-63346, December 2, 2010; Release No. 34-63236, November 8, 2010; Release No. 34-63107, October 26, 2010.}

^{18. The SEC released this report in January, 2011 and indicates it will propose corresponding rules by July 2011.}

^{19. The SEC indicates that it will propose rules on these topics by July, 2011.}

^{20. The SEC indicates it intends to propose rules on this topic by July, 2011.}

^{21. The latter study, Study and Recommendations on Improved Investor Access to Registration Information About Investment Advisers and Broker-Dealers, was released in January 2011.}

^{22. See Release 3110.}

^{23. See, for example, NCCUSL's adopting comments respecting §§1-102(15) (the definition of "investment adviser"), 4-403 (registration requirement), 4-405 (notice filing requirement for SEC-registered advisers), 4-411(b) and 5-505 (definition of "material" in respect of the duty to update information filed with the MSD).}

^{24. Note that such time span is much shorter than prior to NSMIA -- the last time Congress dramatically reduced the number of federally-registered advisers (from 22,400 in 1996 to 6,650 in 1999). According to the 914 Study, many advisers would not be examined more than once every 25-30 years prior to NSMIA.}

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.