In a three-to-two vote,1 the Securities and Exchange Commission (the "SEC") proposed a new rule and rule amendments that, if adopted, would require advisers to certain private investment pools, such as hedge funds, to register with the SEC under the Investment Advisers Act of 1940, as amended (the "Advisers Act"). As described in Release No. IA-2266 (the "Release"), this proposal would also modify certain provisions of the rules adopted under the Advisers Act concerning custody of client funds, recordkeeping and performance fees. The SEC has also proposed to amend Form ADV to require advisers to hedge funds to identify themselves as such.2 A number of comments discussing specific provisions as well as the general utility and statutory basis for the proposal were received by the SEC during the comment period, which officially ended September 15, 2004.3
Rationale for the Proposal
The Release cites a number of reasons for the proposal, including: (i) the increase in the number and size of hedge funds, (ii) growth in "hedge fund fraud," and (iii) increased exposure of smaller investors, directly or indirectly, to hedge funds ("Retailization").
The Release also lists a number of benefits that the SEC believes would result from registration of advisers to private investment funds, including (i) better information on hedge funds, (ii) deterrence and early discovery of fraud, (iii) exclusion of unfit persons from the hedge fund business, (iv) adoption of compliance controls and (v) limitation on Retailization.4
The Current Rule
Section 203(b)(3) of the Advisers Act exempts from registration investment advisers that during the preceding 12 months have had fewer than 15 clients, do not advise an investment company registered under the Investment Company Act of 1940, as amended, nor "hold themselves out to the public" as investment advisers. Rule 203(b)(3)-1 under the Advisers Act currently treats a legal organization (such as a private investment fund) that receives investment advice based on its investment objectives and not the individual investment objectives of its owners as a single client. Thus, under the current rule, private investment fund managers that comply with the other terms of Section 203(b)(3) can advise up to 14 private funds in any 12-month period without registering under the Advisers Act.
Proposed "Look Through" for Advisers to "Private Funds"
If adopted, new Rule 203(b)(3)-2 would require investment advisers to count each owner of a "private fund" as a client for purposes of determining the availability of the Section 203(b)(3) private adviser exemption. Proposed Rule 203(b)(3)-2 defines a "private fund" as a company: (i) that would be an investment company under Section 3(a) of the Investment Company Act of 1940, as amended (the "Investment Company Act") but for the exception provided from that definition by either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act;5 (ii) that permits its owners to redeem any portion of their ownership interests within two years of the purchase of such interests; and (iii) in which interests have been offered based on the investment advisory skills, ability or expertise of the investment adviser.
The Release indicates that the exemption for funds not permitting redemptions (other than for extraordinary and unforeseen circumstances and for reinvested dividends) within two years of purchase is designed to exclude advisers to private equity funds from the proposed registration requirements. The SEC states that it has not encountered significant enforcement problems with private equity funds. Depending on the language in the final rule, hedge fund advisers may be able to avoid registration by effectively imposing a two-year lock-up on the principal amount invested in the fund. It is unclear whether a fund could impose a two year lock-up upon adoption of the proposed rule, and allow investors who had been continuously invested prior to imposition of the two year lock-up to count the time assets were invested prior to imposition of the lock-up towards the two year requirement.
The proposed rule also would require advisers to hedge funds to "look through" any "top tier" funds, registered or unregistered, that invest in the hedge fund advised by such adviser in determining whether the adviser has more than 14 clients.
Offshore advisers would be subject to the same "look through" requirements but would be required to register only if they have more than 14 investors or other advisory clients that are U.S. residents. However, advisers to offshore funds that are regulated as public investment companies under the laws of a country other than the United States would not have to "look through" such public funds for the purpose of counting the number of U.S. clients they advise under Section 203(b)(3).6
Provided that both the adviser and the fund have their principal offices and places of business outside the United States, offshore advisers required to register because they have more than 14 U.S. investors in the private offshore funds they advise, would not be subject to any of the substantive requirements of the Advisers Act with respect to such offshore funds, including offshore funds that are owned exclusively by U.S. investors. They would, however, be subject to the substantive Advisers Act requirements to the extent they have a direct U.S. advisory client.
Amendments To Current Rules
Limited Relief Permitting Continued Advertising of "Track Records"
Under Rule 204-2(e)(3), a registered adviser that makes claims concerning its performance must maintain documentation supporting those performance claims for a period of five years after the performance information is last used. As proposed, an adviser to a "private fund" that was exempt from registration prior to the effectiveness of the proposed rule will continue to be able to use performance information for periods prior to its registration for a private fund it advises (but not managed accounts) even if the adviser has not retained the necessary supporting information as required by Rule 204-2. The adviser would, however, be required to retain whatever records it does have - i.e., the recordkeeping requirement would apply to records in the adviser's possession as of the date it registers. This provision and the "grandfathered" performance fee described below, may create an incentive for unregistered advisers contemplating registration to wait to see if the proposed rule is adopted because neither provision is available to advisers registered before the effective date of the proposed rule.
Limited Relief from Prohibition on Performance Fees
Registered investment advisers are generally prohibited from charging a performance fee to clients who are not "qualified clients."7 Qualified clients are generally investors, either individuals or companies, that invest at least $750,000 with an investment adviser or that have a net worth of at least $1.5 million, and also include the adviser's executive officers, directors, certain "knowledgeable employees" and Qualified Purchasers as defined in Section 2(a)(51)(A) of the Investment Company Act. The proposed amendment to Rule 205-3 would "grandfather" from this requirement investors in a private fund that were investors before the adviser was required to register with the SEC. Grandfathered investors would be permitted to add to their accounts, but not to open new investment accounts in the hedge fund or in other hedge funds managed by the same adviser. Absent this exemption, advisers would have to require investors that are not qualified clients to withdraw from the investment fund before the adviser registered under the Advisers Act, or forego charging those investors a performance fee. The proposal would grandfather only investors in private funds and not other investors in other advisory arrangements.
Expansion of Exemption in the Custody Rule
The proposed rule would modify an exemption available to pooled investment vehicles under Rule 206(4)-2 (the "Custody Rule"). Currently, advisers to pooled investment vehicles (such as private funds) are not required to comply with the surprise audit and reporting requirements of the Custody Rule if they distribute audited financial statements of the investment vehicle prepared in accordance with generally accepted accounting principles to all fund investors within 120 days of the end of the investment vehicle's fiscal year. The proposed rule would extend the required delivery date to no later than 180 days after the end of the fiscal year. This extension was designed principally for funds of hedge funds, which often are unable to meet the 120-day deadline because they cannot complete their financial statements until they receive financial statements from all the funds in which they were invested during the preceding year. The SEC stated in the Release, Note 159, that until it takes action on this proposal, 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. As proposed, the extension of the 120-day deadline to 180 days would apply to all private funds; however, this temporary relief by its terms applies only to funds of funds.
State Registration Of Employees Of SEC Registered Advisers
The proposal would not alter the current division of adviser regulation between the SEC and the state regulators. Generally, Section 203A of the Advisers Act does not permit registration with the SEC unless an adviser has assets under management of $25 million dollars or more, and preempts state registration of advisory firms registered with the SEC.8
The proposed rule, because it revises the definition of "client" for purposes of the Advisers Act regulations, would have an apparently unintended effect on the availability of the exemption from state registration for employees of SEC registered advisers. Section 203A of the Advisers Act exempts a federally registered adviser from state registration while permitting a state to require the registration of an "investment adviser representative" working for a federally registered adviser that has a place of business in that state. Rule 203A-3 limits the definition of "investment adviser representative" to a supervised person9 of an investment adviser with more than five clients who are natural persons and not "qualified clients" and who represent more than ten percent of such supervised person's clients. Rule 203A-3 further provides that a supervised person may rely on Rule 203(b)(3)-1 for purposes of identifying his or her clients. As a result, currently supervised persons of an investment adviser managing a hedge fund would count the fund as the "client" and in most instances would have fewer than five, and often no, clients who are natural persons.
Under the proposed rule, supervised persons of investment advisers managing hedge funds may lose the availability of the Section 203A exemption, depending on the number of investors in the fund who are natural persons but not qualified clients. Registered investment advisers are generally prohibited from charging a performance fee to clients who are not "qualified clients." However, since the proposed rule would "grandfather" from this prohibition existing investors in a private fund, many hedge fund advisers will be able to continue to charge a performance fee after registration even though a large proportion of the investors in the hedge fund may not be qualified clients. At the same time, however, many employees of such advisers could become subject to registration (and related testing and other requirements) under state law10 because they may have more than five "clients" (investors in such funds) who are natural persons but not qualified clients.
The SEC's proposal, if adopted, will result in many advisers to private funds becoming subject to SEC registration and many of their employees to registration with the states. In light of the increasing regulatory requirements being imposed on registered investment advisers,11 many unregistered hedge fund advisers may, if the proposal is not modified, opt to restructure their private funds to take advantage of the proposed exemption for private funds with a two-year investment commitment. Additionally, the "grandfathering" and other relief provided for advisers registering after the adoption of the proposal is an incentive for advisers currently contemplating registration to wait to see if the proposal is adopted and the nature of the final provisions before doing so.
1 Commissioners Glassman and Atkins dissented from the majority's proposal.
2 In item 7B of Part 1A and Schedule D of Form ADV. See the Release, Part II.I.
3 Release No. IA-2266 (the "Release"). A copy of the proposal is available on the SEC's Web site at http://www.sec.gov/rules/proposed/ia-2266.htm. The dissent of Commissioners Atkins and Glassman is found at http://www.sec.gov/rules/proposed/ia-2266.htm#dissent. Comments are available at http://www.sec.gov/rules/proposed/s73004.shtml.
4 See the Release, Part I.A. and Part II.B. 1 through 5.
5 Section 3(c)(1) exempts from registration any issuer the outstanding securities of which are beneficially owned by not more than 100 persons and that does not make a public offering of its securities. Section 3(c)(7) exempts from registration any issuer the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are "qualified purchasers," and that does not make a public offering of such securities. "Qualified Purchaser" is defined in Section 2(a)(51)(A) of the Investment Company Act. Private investment funds, including hedge funds and private equity funds, generally rely on one of these exemptions.
6 Proposed Rule 203(b)(3)-2(d)(3). The public fund must have its principal place of business outside the United States, make a public offering of securities in a country other than the United States and be regulated as a public investment company under the laws of a country other than the United States.
7 Section 205(a)(3) of the Advisers Act prohibits such fees with some exceptions, and Rule 205-3 provides an exemption for "qualified clients."
8 Certain other advisers in specific categories are allowed to register with the SEC without the requisite assets under management, including newly formed advisers that believe they will have the requisite assets under management within 120 days of registration or advisers to $50 million in pension plan assets.
9 Section 202(a)(25) of the Advisers Act defines "supervised person" as any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser.
10 Most state securities laws require the registration of certain employees of advisers, which often involves passing the Series 65 examination, the filing of Form U-4 (which requires disclosures concerning employment, residential and disciplinary history) on the SEC's IARD system or in paper form with the state and the payment of fees. Additionally, the definition of "client" would also change for the de minimis exemption from state investment adviser registration for advisers not registered with the SEC (Section 222(d) and Rule 222-2).
11 An adviser that becomes registered with the SEC becomes subject to the requirement to create, file and keep current Form ADV, the recordkeeping requirements of Rule 204-2, the performance fee requirements of Rule 205-3, the custody requirements of Rule 206(4)-2, the solicitor requirements of Rule 206(4)-3, the proxy voting requirements of Rule 206(4)-6, the recently adopted compliance officer and compliance procedures requirements of Rule 206(4)-7, and the Code of Ethics provisions of Rule 204A-1, among others. Additionally, registered advisers have been subject to increasingly frequent inspections by the SEC staff.
Martin R. Miller is Special Counsel and Joseph Bergman is an Associate in the Corporate and Financial Services Department in the New York City office of Willkie Farr & Gallagher LLP.