The SEC released its proposed rules that will require hedge fund managers to register under the Investment Advisers Act of 1940 (the "Act") on July 20, 2004. Comments are due on the proposal by September 15, 2004, which may be delayed until 60 days after the proposed rule is published in the Federal Register.
Limited Relief From Custody Rule Deadlines
An immediate effect of the proposal is limited no-action relief to registered fund of funds managers from the current requirements of the custody rule. Currently, managers of pooled investment vehicles are not required to deliver account statements to investors if they distribute annual audited accounts within 120 days of year end. Most funds of hedge funds cannot complete their annual audit within 120 days since they must first receive audited statements from the underlying funds. The proposal would extend the period to distribute audited statements to 180 days to make it possible for fund of funds managers to qualify for the exemption. Footnote 159 of the proposal states that the Division of Investment Management will not recommend that the SEC take any enforcement action against an adviser to a fund of funds that acts in accordance with the proposed amendment while the proposal is pending.
Method Of Determining Number Of Clients For PrivateAdviser Exemption
Upon coming into force, the proposed new rules would restrict the availability of certain exemptions to the registration requirements of the Act which are currently relied upon by many hedge fund advisers to avoid registration. Under the Act, an investment adviser which is not excluded from the statutory definition of "investment adviser" or which is not otherwise exempt from the application of the Act is required to register with the SEC.1
Pursuant to Section 203(b)(3) of the Act, an investment adviser is not required to register if it (i) has fewer than fifteen (15) clients during the preceding 12 months, (ii) does not hold itself out generally to the public as an investment adviser, and (iii) is not an adviser to any registered investment company.2 This exemption is commonly referred to as the "private adviser exemption" and is the exemption most often used by hedge fund advisers to avoid registration under the Act.
Rule 203(b)(3)-1 under the Act provides guidance in relation to the definition of "client." Under this rule, an investment adviser may count a legal organization as a single client so long as the investment advice is provided based on the objectives of the legal organization rather than the individual investment objectives of any owner of the legal organization.3 Accordingly, many hedge fund advisers currently qualify for the "private adviser exemption" even if they advise organizations with more than fourteen (14) investors.
The SEC (through new proposed Rule 203(b)(3)-2) proposes that an investment adviser of a "private fund" count each owner of such fund as a client for purposes of determining the availability of the "private adviser exemption." For these purposes, the SEC proposed to define a "private fund" as any company (which would include trusts, and partnerships):
(i) that would be subject to regulation under the Investment Company Act of 1940 but for the exception provided in either section 3(c)(1) or section 3(c)(7) of such Act,
(ii) that permits investors to redeem their interests in the fund within two years of purchasing them, and
(iii) interests in which are or have been offered based on the investment advisory skills, ability or expertise of the investment adviser.
The effect of this new rule would be to disqualify many hedge fund advisers from relying upon the "private adviser exemption" to avoid registration under the Act, and to increase the number of hedge fund advisers that are required to register.
In addition, the SEC has proposed that an adviser to "private fund" in which a registered investment company invests would further have to look through that registered investment fund to count all ultimate investors as clients.
The proposed rule changes do not affect the general rule that an adviser must have at least $25,000,000 in assets under management in order to be eligible to register with the SEC.
Relief For Offshore Advisers And "Grandfather" Provisions
The SEC also proposed certain exemptions and grandfather clauses as follows:
Non-U.S. advisers would only have to count U.S. residents, not foreign residents, that were invested in its funds or were otherwise advisory clients in the previous 12 months. Advisers doing business in the U.S., in contrast, must count all of their investors, U.S. or non-U.S.
Non-U.S. advisers to non-U.S. mutual funds or closed-end funds would not have to count investors in any such funds that:
are publicly offered outside the U.S.,
have their principal office and place of business outside the U.S., and
are regulated as a public investment company under the laws of a foreign jurisdiction.
Non-U.S. advisers to non-U.S. private funds would have to look through their "private funds" only for determining the number of clients (counting U.S. residents only) and for application of the anti-fraud provisions of the Act. For all other purposes of the Act the SEC has proposed to allow non-U.S. advisers to treat their non-U.S. hedge fund as the client, thereby exempting them from the substantive provisions of the Act, such as performance-based compensation, custody and record-keeping requirements.
Previously unregistered advisers that become required to register as a result of the rule changes will be granted the following relief from requirements of the Act:
Ability to make claims regarding their performance track record even if they have not maintained the records ordinarily required to support such claims for periods prior to effectiveness of the amendments;
Ability to receive performance-based compensation from existing investors even if they do not meet the "qualified client" standards.
The proposed rules would also make changes to Form ADV to require advisers to "private funds" to so indicate on the form.
Two SEC commissioners joined in writing a dissent to the proposal and witnesses in Senate hearings on the issue, including Federal Reserve Chairman Alan Greenspan, have been blunt in questioning the efficacy of the proposal.
The full text of the proposed rules and the dissent are available at http://www.sec.gov/rules/proposed/ia-2266.htm.1 Please note that the Release does not constitute the rules or regulations which may only come into force and effect after adoption by the SEC. The release only sets forth the proposed rules and regulations of the SEC and its request for public comments to those proposals.
2 The Act also contains several other registration exemptions, which have much more limited application.
3 See Rule 203(b)(3)-1(a)(2)(i).
Marilyn Selby Okoshi is a partner in the New York office of Coudert Brothers LLP. Her practice is in the area of finance, structured finance, derivatives and investment funds. She can be reached at (212) 646-4756. Christopher M. Wells is also a partner in the firm's New York office and head of the firm's investment fund group. This article does not constitute legal advice.