Client Alert

Funds U.S. Regulatory Alert

December 2009

Congress Edging Closer to Passing Legislation Requiring Registration of Hedge Fund and Private Equity Fund Managers

Overview

The U.S. Senate and the U.S. House of Representatives are edging closer to passing legislation that would require most hedge fund managers to register as investment advisers with the SEC. Most private equity fund managers would be required to register pursuant to legislation approved in November by the House Committee on Financial Services (the "House Bill"),^[1] but would be exempt from registering under legislation proposed in the Senate in November by Senator Christopher Dodd, Chairman of the Banking, Housing and Urban Affairs Committee (the "Dodd Bill").^[2] Venture capital fund managers would be exempt from registering under both proposed bills but would be subject to recordkeeping and reporting requirements. The bills are similar to proposed legislation introduced by the Obama Administration in July (the "Obama Proposal"),^[3] which would require registration of almost all private fund managers, without exception. In addition, all of the proposed bills would impose enhanced recordkeeping and reporting requirements on hedge fund and private equity fund managers. Both the House Bill and the Dodd Bill substantially raise the amount of assets under management necessary to be exempt from federal registration - to $150 million in the House Bill, and to $100 million in the Dodd Bill - but managers who manage less than that amount would be subject to state investment adviser registration rules, as well as federal recordkeeping requirements. A number of foreign private fund managers would also be required to register under all of the proposed bills. Both the House Bill and the Dodd Bill also include other provisions relevant to fund managers, including custody requirements and increasing certain investor financial requirements.

The parameters of any final legislation are still unclear, though all of the proposed legislation introduced in 2009 has consistently required the registration of hedge fund managers and enhanced reporting requirements. Only the recently proposed Dodd Bill has exempted private equity fund managers. It is currently anticipated that legislation will be enacted during the first half of 2010, though the process has already taken longer than initially expected. Any legislation will presumably include a lengthy transition period, as in the case of the House Bill, which provides that the new requirements will take effect one year after enactment. We will continue to keep you informed of further developments.

Current Registration Exemption for Private Advisers

Under current law, investment advisers with $30 million in assets under management are required to register with the SEC under the Investment Advisers Act of 1940 (the "Advisers Act") unless they fit within an exemption. Many hedge fund managers and most private equity fund managers rely on the "private adviser exemption" under Advisers Act Section 203(b)(3), which, among other things, exempts advisers that have fewer than 15 clients, with each fund counted as one client.^[4] Non-U.S. fund managers only need to count U.S. clients (i.e., funds organized in the U.S.) toward the client limit, and therefore many non-U.S. fund managers rely on the private adviser exemption. Advisers with under $25 million in assets under management are subject to state investment adviser laws, and many states have their own exemptions from registration.^[5]

Elimination of Private Adviser Exemption - No Hedge Fund Exemption

Under all of the proposed bills, the "private adviser exemption" in Section 203(b)(3) would be eliminated entirely. Accordingly, managers of hedge funds and private equity funds will have no exemption from registration upon which to rely, unless a bill specifically includes a carve-out for a specific type of manager. None of the proposed bills have included a carve-out for hedge fund managers, and registration bills introduced earlier in 2009 were specifically entitled "hedge fund registration" acts.

Private Equity Fund Manager Exemption Only in Dodd Bill

The Dodd Bill, unlike the House Bill and the Obama Proposal, exempts from registration an adviser to a "private equity fund," and leaves to the SEC the task of defining "private equity fund." To the extent this exemption makes it into final legislation, the SEC might define a "private equity fund" based on the length of a fund's lock-up period, as the SEC did when it adopted a rule in 2004, later overturned by the U.S. Court of Appeals, that required an adviser to count as clients the investors in the funds managed by the adviser. The Dodd Bill focuses on assessing the systemic risk by private funds, and presumably, Senator Dodd would argue that private equity funds do not pose sufficient systemic risk to require their managers to register. It remains to be seen whether the House and Senate will agree with that assessment.

Although the Dodd Bill would not require private equity fund managers to register or comply with the same reporting requirements as registered advisers, the Dodd Bill provides that the SEC shall issue rules to require private equity fund managers to maintain records, and provide reports, as the SEC determines is necessary. Accordingly, the SEC could decide to impose rigorous reporting requirements on private equity fund managers, even if they are not otherwise required to register.

Recordkeeping and Reporting Requirements

All of the proposed bills would require a registered adviser to a "private fund" to file reports with the SEC, and to maintain records regarding the fund, as to be determined by the SEC, and to maintain other records and reports as are necessary for the assessment of "systemic risk." The House Bill provides that the Board of Governors of the Federal Reserve System must consult with the SEC on the required systemic risk reports and may also receive the reports. The Dodd Bill has the same requirement, except that it gives the Fed's role to a newly created Agency for Financial Stability. Both proposed bills provide that specific information must be reported, including a fund's use of leverage, off-balance sheet leverage, counterparty credit risk exposure, and trading and investment positions. The Dodd Bill also requires reporting of a fund's valuation methodologies and side letters. The proposed bills give the SEC the authority to determine the details of the reporting requirements. The House Bill notes that the SEC may set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds. Both the House Bill and Dodd Bill clarify that the SEC in its rulemaking may prescribe different requirements for different classes of persons and matters.

Disclosure of Reports to Third Parties

The House Bill and the Obama Proposal, but not the Dodd Bill, provide that a registered private fund adviser must provide reports not only to the SEC but to investors, prospective investors, counterparties and creditors of any private fund advised by the manager, as the SEC may prescribe. This disclosure requirement is a completely new requirement and could fundamentally change the scope of information that must be made available by a fund manager.

Registration Exemption for Smaller Fund Managers

Unlike the Obama Proposal, both the House Bill and the Dodd Bill substantially increase the amount of assets under management necessary in order to be required to register as an adviser with the SEC. The House Bill provides an exemption for an adviser of private funds if each of such private funds has assets under management in the U.S. of less than $150 million. Accordingly, under this provision, a fund manager could manage in total much more than $150 million without being required to register, as long as each separate fund only has less than $150 million. In addition, since the House Bill exemption only refers to private fund managers, it would continue to require other advisers (such as advisers who only have separately managed accounts) to register at the current level of $30 million of assets under management. In contrast, the Dodd Bill raises the level of assets under management necessary for federal registration to a level of at least $100 million for all advisers, without reference to private funds.

Since an increase is in both bills, it seems more likely that final legislation will include a provision raising the minimum amount of assets under management necessary for federal registration. Nevertheless, advisers who do not meet the minimum amount will still be subject to state investment adviser registration requirements, and some states may decide to change their current registration exemptions to require fund managers to register. In addition, the House Bill provides that advisers exempt from registration based on assets under management will nevertheless still be subject to recordkeeping and reporting as determined by the SEC, so they could still end up being subject to rigorous reporting requirements.

Mid-Sized Fund Managers

The House Bill, but not any other bill, provides that in prescribing regulations relating to managers of "mid-sized" private funds, the SEC must take into account the size, governance and investment strategy of such funds to determine whether they pose systemic risk, and registration and examination procedures for such funds should reflect the funds' systemic risk. The House Bill does not define "mid-sized" private fund. To the extent this provision makes it into any final legislation, it may be difficult for the SEC to adopt any meaningful rules implementing it.

Non-U.S. Fund Managers

All of the proposed bills have exempted from registration "foreign private advisers," with some differences in the exact definition. The House Bill and the Dodd Bill both define a "foreign private adviser" as an adviser that: (i) has no place of business in the U.S.; (ii) has fewer than 15 clients in the U.S.; (iii) has assets under management attributable to clients in the U.S. of less than $25 million (or such higher amount as the SEC may determine); (iv) does not hold itself out in the U.S. as an adviser; and (v) does not advise a registered investment company. It is unclear how "client" will ultimately be defined. The House Bill specifically prohibits the SEC from defining "client" as including the investors in a fund, though the Dodd Bill does not include that provision. If "client" ends up including the investors in a fund, then the scope of the registration requirement would be broad, and would include any fund manager that has either 15 U.S. investors in any of its funds or $25 million from U.S. investors in any of its funds. In addition, since the definition requires that the fund manager has "no place of business" in the U.S., as opposed to no "principal" place of business, foreign fund managers would not be able to have any U.S. office at all without being registered. Furthermore, some non-U.S. fund managers rely on an exemption for registered Commodity Trading Advisers, but that exemption is also being limited, as noted below.

Scope of "Private Fund" Definition

As noted above, the scope of the reporting requirements and some of the registration exemptions are based on being an adviser to a "private fund." The House Bill defines a "private fund" as any issuer that relies on an exemption from registration as an investment company under Investment Company Act Section 3(c)(1) (the 100-investor exemption) or Section 3(c)(7) (the qualified purchaser exemption). The Dodd Bill and the Obama Proposal add to the definition of "private fund" the requirement that the fund either: is organized in the U.S., or has 10% or more of its securities owned by U.S. persons. Accordingly, the House Bill definition would include a much larger number of funds and would reach any fund managed by an adviser subject to the legislation, not just funds with some link to the U.S.

Venture Capital Fund Exemption

Both the House Bill and the Dodd Bill completely exempt managers of "venture capital funds" from the registration requirements, but both bills still subject venture capital fund managers to reporting and recordkeeping requirements as the SEC may determine. The bills also require the SEC to define "venture capital fund." It is unclear how expansive a definition the SEC would adopt.

Commodity Trading Adviser Exemption

Under current law, an investment adviser that is registered with the Commodity Futures Trading Commission (CFTC) as a Commodity Trading Adviser ("CTA"), and who does not primarily act as an investment adviser, is exempt from registering as investment adviser under Advisers Act Section 203(b)(6). Both the House Bill and the Dodd Bill would no longer allow an adviser to a "private fund" to use the CTA exemption (but the exemption would otherwise still be available to other advisers).

Family Office Exemption and Other Exemptions

The Dodd Bill, but not any other bill, would completely exempt from all registration and reporting requirements any "family office." The Bill leaves to the SEC the task of defining "family office." Both the House Bill and the Dodd Bill would disallow an adviser to a "private fund" from using the intrastate exemption in Section 203(b)(1). The House Bill would completely exempt an adviser who solely advises small business investment companies licensed under the Small Business Investment Act of 1958.

Custody Requirements

The Dodd Bill provides that the SEC shall prescribe rules requiring all registered advisers to use an independent custodian to hold client assets, though the SEC can decide to do so only where necessary and appropriate for the protection of investors. Another proposed bill, the Investor Protection Act, which was approved by the House Financial Services Committee on November 4, 2009, similarly provides that the SEC must adopt a rule making it unlawful for registered advisers to have custody of more than $10 million of client funds or securities unless the funds are maintained with a qualified custodian that does not provide investment advice with respect to such securities.

Investor Requirement Provisions

Both bills change certain investor financial requirements, but will not affect funds that only have "qualified purchasers." The Dodd Bill provides that the "accredited investor" standard, which is a requirement for investors in Regulation D private offerings, shall be adjusted by the SEC periodically to reflect price inflation. The House Bill provides that the "qualified client" standard in the Advisers Act be periodically adjusted for inflation by the SEC. (Registered advisers, including fund managers who are registered, can only charge incentive or performance fees to investors in a fund (and to clients generally), if they meet the "qualified client" standard.

General Requirements of a Registered Adviser

To the extent you will be required to register under any final legislation, the following briefly describes the requirements. In general, a registered investment adviser: must file with the SEC, and keep current, a Form ADV; must maintain compliance policies and procedures, which are supposed to be drafted based on the specific business and potential compliance issues relevant to the adviser; must hire a Chief Compliance Officer, who is supposed to have a general understanding of the Advisers Act requirements, but need not have passed any specific exam; is required to maintain detailed records and reports, including all electronic communications by employees; is subject to additional rules applicable only to registered advisers, such as specific custody requirements; and is subject to periodic examinations by the SEC of the adviser's records. In addition to the usual examination requirements, both the House Bill and the Dodd Bill provide that a registered adviser will be subject to periodic and special examinations by the SEC of the records of a private fund advised by the manager. It is expected that the SEC's budget will be substantially increased to allow the SEC to engage in additional examinations of registered advisers, as only a small portion of registered advisers currently undergo any examination at all.

For Further Information
The author of this Alert is Adam D. Gale. For further information, please contact him or any member of the Chadbourne & Parke Funds team:

^{[1] H.R. 3818, entitled the "Private Fund Investment Advisers Registration Act of 2009." The House Bill, which was sponsored by Congressman Paul Kanjorski (D-PA), was approved by the House Committee on Financial Services by a vote of 67-1 on October 27, 2009, after a full committee markup of the discussion draft.
[2] "Restoring American Financial Stability Act of 2009," introduced on November 10, 2009.
[3] "Private Fund Investment Advisers Registration Act of 2009," released by the U.S. Department of the Treasury on July 15, 2009, which was based on the Treasury Department's June 17, 2009 proposal, "Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Regulation."
[4] The other requirements for the exemption are that: (i) the adviser cannot advise a registered investment company (such as a mutual fund); and (ii) the adviser cannot publicly advertise ("hold itself out to the public") as an adviser.
[5] Advisers with $25 million - $30 million in assets under management who do not fit within an exemption can elect state or federal registration}