Investment advisers to multiple hedge funds and other unregistered investment pools often seek to rebalance the portfolios of such pools (and separately managed accounts). When rebalancing, the adviser may sell securities for one or more unregistered pools (or managed accounts) and purchase the securities for one or more of its other unregistered pools (or managed accounts) in a simultaneous transaction (i.e., a "cross transaction"). Because investment advisers and their personnel frequently invest in the unregistered pools which they manage, there is a concern that a rebalancing or other cross transactions could be viewed as a "principal transaction" subject to the notice and consent requirements of Section 206(3) of the Investment Advisers Act of 1940. Unfortunately, little guidance exists regarding the threshold percentage of an unregistered pool that must be owned by the fund's investment adviser and the adviser's personnel before the pool would be deemed to be a principal account of the adviser for purposes of Section 206(3).
On June 7, 2006, the staff of the Securities and Exchange Commission ("SEC") issued a no-action letter which provides that a registered investment adviser to two private unregistered investment funds may engage in cross transactions between the two funds without obtaining client consent as long as the adviser has less than a 25% ownership interest in each fund.1 This no-action letter has important implications for hedge fund and other fund managers, whether or not the manager is registered with the SEC as an investment adviser.
The request for relief involved an investment adviser to various client accounts including two investment limited partnerships (the "Funds"). According to the request letter, an entity that controlled the adviser acted as the general partner of the Funds and held a 6.237% interest in one Fund and a 1.4405% interest in another Fund. Neither the adviser nor any of its employees had an ownership interest in the Funds. Due to timing of capital flows into and out of the client accounts and the Funds, the adviser from time to time sells a particular security from one account or Fund that it is contemporaneously acquiring for another account or Fund. The adviser sought assurances from the SEC that it would not recommend enforcement action if it crossed the trades of a Fund with another account (or Fund) primarily to reduce transaction costs.
The SEC previously has taken the position that the application of Section 206(3) depends upon whether the adviser and its principals own "significant ownership interests" in the accounts they manage and on other facts and circumstances.2 In the recent no-action letter, the SEC sets forth two significant factors for determining whether a client account would be viewed as a principal account: (1) the nature of the relationship of the owners of the account to the investment adviser, and (2) the extent of the ownership interest of the investment adviser and/or its personnel in the account. As stated above, the SEC concluded that an account in which an adviser and/or its controlling persons own in excess of 25% of the interests would constitute a principal account for purposes of Section 206(3), while an account in which 25% or less of the ownership interests are owned by such persons would not constitute a principal account for purposes of Section 206(3). Accordingly, the SEC effectively has defined a "significant ownership interest" to exist at 25%.
In granting the relief, the SEC (not surprisingly) confirmed its view that the ownership interest of a controlling person of an investment adviser is considered to be the ownership interest of the adviser itself. While the recent no-action letter provides greater clarity as to what accounts do and do not constitute principal accounts, certain questions remain unresolved. For example, the SEC did not address whether an ownership interest in a client account by non-controlling or former personnel of the adviser, or by family members of such persons, would be included for purposes of the "25% test."
The SEC also noted that ownership interests of an investment adviser and/or its controlling persons of 25% or less of an account still may present the opportunity for significant conflicts of interest between an investment adviser and its clients, creating incentives to overreach and treat unfairly the clients with which the account engages in transactions. Cross transactions involving such an account therefore may implicate Sections 206(1) and (2) of the Investment Advisers Act (general anti-fraud provisions). It is important to note that Section 206 of the Investment Advisers Act, including the principal transaction requirements of Section 206(3), apply to all investment advisers, whether or not registered as such. Moreover, cross transactions may continue to be prohibited by other regulations, such as the Employee Retirement Income Security Act of 1974 (ERISA) even though permitted under the Investment Advisers Act.1 See Gardner Russo & Gardner (June 7, 2006, File No 801-41357), available at www.sec.gov/divisions/investment/noaction/gardener)60706.htm.
2 Letter from the Office of Chief Counsel, Division of Investment Management, SEC to Subcommittee on Private Investment Entities, American Bar Association (Dec. 8, 2005), available at www.sec.gov/divisions/investment/noaction/aba120805.htm.
Wesley G. Nissen is a Partner in Winston & Strawn's financial services practice group who concentrates his practice on the representation of asset managers of all types. He has significant experience with securities and commodities registration, regulation, and compliance matters. He also has assisted with the formation of and provided general representation to various hedge funds, private investment funds, and commodity pools. In addition, he has been involved in a number of significant domestic and international merger and acquisition transactions in the financial services industry. Mr. Nissen is general counsel of the Foundation for Managed Derivatives Research, a nonprofit organization that provides grants for research on the use of derivative instruments as an investment vehicle.