On July 21, 2010, President Obama signed into law the Private Fund Investment Advisers Registration Act of 2010 (the “Registration Act”) as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Registration Act includes amendments to the Investment Advisers Act of 1940 (the “Advisers Act”) that will require many investment advisers to private investment funds to register with the Securities and Exchange Commission (the “SEC”) under, and comply with, the Advisers Act, and increases recordkeeping and reporting obligations for both registered and certain unregistered advisers, among other changes.
A number of investment advisers to private equity, venture capital, real estate, hedge and other investment funds currently rely on the “private adviser” exemption from registration under the Advisers Act. The private adviser exemption is available to an investment adviser with fewer than 15 “clients” that does not hold itself out generally to the public as an investment adviser and does not advise mutual funds or business development companies. Many private equity, venture capital, real estate, hedge and other private fund managers have been able to rely on the private adviser exemption because they can count the funds that they manage as “clients” rather than counting the investors in those funds. The amendments to the Advisers Act eliminate the private adviser exemption, but provide for new exemptions from registration as well as the new reporting and recordkeeping obligations to be established by the SEC for registered and certain unregistered investment advisers described in more detail below.
In addition to the amendments to the Advisers Act, the Registration Act amends the definition of “accredited investor” under the Securities Act of 1933 to adjust the calculation of an individual’s net worth for purposes of that definition, and instructs the SEC to periodically review the definition to determine whether additional adjustments are necessary. This amendment to the definition of accredited investor is effective immediately and should be considered in connection with any currently pending securities offerings to accredited investors.
Unless otherwise noted, the provisions of the Registration Act described below will not become effective until July 21, 2011. In many cases, the provisions require implementing regulations that are yet to be proposed, but are required to be promulgated within the same one-year period. Thus, investment advisers that are currently not registered with the SEC will have 12 months to assess their operations and to adopt and implement appropriate policies and procedures to comply with the Advisers Act and, ultimately, to become registered.
Adviser Registration Under the Registration Act
Elimination of the “Private Adviser” Exemption. The Registration Act eliminates the “private adviser” exemption and will require many investment advisers that are currently exempt from registration to register with the SEC under the Advisers Act, unless another exemption from registration (including one of the new exemptions described below) is available.
New Exemptions from Registration. The Registration Act also includes new exemptions from registration, described in more detail below, for (i) advisers to “venture capital funds,” (ii) “foreign private advisers,” (iii) advisers to certain “private funds” and (iv) advisers to licensed small business investment companies (“SBICs”).1
- Advisers to “Venture Capital Funds.” Advisers that solely advise one or more “venture capital funds” will be exempt from registration under the Advisers Act. The Registration Act does not define “venture capital fund” and instead instructs the SEC to define the term within one year of enactment of the Registration Act. Notwithstanding the venture capital fund exemption, the Registration Act does provide that advisers to venture capital funds will be subject to new recordkeeping and SEC reporting requirements to be established by the SEC. With the new venture capital fund exemption, advisers to venture capital funds will no longer be subject to a 14 client (i.e., fund) limit so long as they are only advising venture capital funds. Although investment advisers that advise both venture capital funds and other types of funds or accounts will be required to register under the Advisers Act (unless another exemption is available), it may be possible to limit the scope of an adviser’s business that is subject to registration and ongoing Advisers Act compliance by separating their venture capital operations from their other operations.
- “Foreign Private Advisers.” Certain non-U.S. advisers may benefit from a narrow exemption from registration under the Advisers Act applicable to “foreign private advisers.” The Registration Act defines a “foreign private adviser” as any investment adviser that (i) has no place of business in the United States, (ii) has, in total, fewer than 15 clients and investors in the United States in private funds (as defined below) advised by the adviser, (iii) has aggregate assets under management attributable to such clients and investors of less than $25 million and (iv) neither holds itself out to the public in the United States as an investment adviser nor advises mutual funds or business development companies.
- Advisers to Certain “Private Funds.” The Registration Act directs the SEC to provide an exemption for those advisers that have assets under management in the United States of less than $150 million and that solely advise “private funds.” The Registration Act defines a “private fund” as any fund that would be an “investment company” under the Investment Company Act of 1940 (the “1940 Act”), but for the exceptions from the definition of “investment company” under Section 3(c)(1) (the 100 beneficial owners exception) or Section 3(c)(7) (the “qualified purchaser” exception) of the 1940 Act. Notwithstanding this exemption, the Registration Act does provide that advisers to private funds that meet the assets under management threshold will be subject to new recordkeeping and SEC reporting requirements to be established by the SEC.
- Advisers to Licensed SBICs. Advisers that solely advise one or more small business investment companies (and/or entities affiliated with any such SBICs that have an application pending with the SBA and/or entities that have received from the SBIC notice to proceed to qualify for a license as an SBIC) will be exempt from registration under the Advisers Act.
Modifications to Existing Exemptions from Registration. The Registration Act also modifies two existing exemptions from registration, described in more detail below, for (i) intrastate advisers and (ii) certain advisers registered with the Commodity Futures Trading Commission (the “CFTC”).
- Intrastate Advisers. The Registration Act maintains the exemption under current law from Advisers Act registration for an adviser whose clients all reside in the state within which the adviser maintains its principal place of business and that does not provide advice with respect to securities listed (or admitted to unlisted trading privileges) on any national securities exchange, but modifies the exemption to provide that no adviser that acts as an investment adviser to a private fund may rely on it.
- Advisers Registered with the CFTC. The Registration Act maintains the exemption under current law from Advisers Act registration for an adviser that is registered with the CFTC as a commodity trading advisor, whose business does not consist primarily of acting as an investment adviser and that does not advise mutual funds or business development companies. The Registration Act also provides an exemption for any adviser registered with the CFTC as a commodity trading advisor that advises a private fund unless the adviser renders predominately securities-related advice.
Exclusion of “Family Offices.” The Registration Act modifies the definition of “investment adviser” to exclude any “family office,” which term is not defined in the Registration Act. The SEC has been instructed to issue rules, regulations or orders regarding the definition of “family office” that recognize the range of organizational, management and employment structures and arrangements employed by family offices (and that provide for certain grandfathering provisions).
Limitations on SEC Registration – “Mid-Sized Investment Advisers.” Under current law, investment advisers that are subject to state regulation in their home states, have less than $25 million in assets under management and do not advise mutual funds are not permitted to register with the SEC. The Registration Act increases the minimum assets under management required for SEC registration to $100 million (or such higher amount as the SEC deems appropriate), and prohibits SEC registration for any such “mid-sized investment adviser” unless such adviser (i) would be required to register in 15 or more states, (ii) advises mutual funds or business development companies or (iii) is not required to be registered and subject to examination in its home state.
Advisers to Private Equity, Real Estate and Hedge Funds. As discussed below, the Registration Act does not (unless clarified through SEC rulemaking) provide exemptions from registration for advisers to private equity, real estate or hedge funds.
- Private Equity Funds. A prior version of the Registration Act approved by the U.S. Senate contained an exemption for advisers to “private equity funds,” but this exemption was not included in the final version of the Registration Act that was signed by President Obama. Unless private equity funds are included in the definition of “venture capital funds” (it is not clear at this time how broadly or narrowly that term will be defined by the SEC and to what extent advisers to certain private equity funds may be able to rely on the venture capital fund exemption), or another exemption from registration is otherwise available, advisers to private equity funds that currently rely on the private adviser exemption will be required to be registered under the Advisers Act no later than July 21, 2011.
- Real Estate Funds. The Registration Act also does not provide an exemption for (or otherwise refer to) advisers to “real estate funds.” An investment adviser to real estate funds that is currently relying on the private adviser exemption will now have to (i) make a determination as to whether another exemption is available and/or (ii) do an analysis (not required to be undertaken previously as a result of having been able to rely on the private adviser exemption) as to whether it can conclude that, based on its investment strategy, it does not fall within the definition of an “investment adviser” under the Advisers Act as an initial matter (and is therefore not required to rely on an available exemption).2 Real estate fund advisers that restrict their investments to real property held directly in their funds or through wholly owned subsidiaries may be able to conclude that they do not fall within the definition of “investment adviser,” but advisers that wish to have the flexibility to invest in securities, such as REIT stock, mortgages or mezzanine debt, or wish to have broad flexibility in structuring co-investment arrangements among parallel funds or with third parties, may find it difficult to conclude that they are not advising their funds and other clients with respect to securities.
- Hedge Funds. Earlier legislative proposals with respect to the Advisers Act were specifically targeted at the registration of advisers to hedge funds, and the Registration Act provides few exemptions that might benefit such advisers.
Recordkeeping and Reporting Requirements
For Registered Advisers. The Registration Act enhances the SEC’s recordkeeping, reporting and inspection authority over registered investment advisers and the private funds that they advise. The SEC is permitted to require registered investment advisers to maintain records of, and file with the SEC reports regarding, private funds advised by such advisers, as is necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk. In addition to any other information that the SEC determines is necessary and appropriate, the Registration Act requires registered advisers to maintain (and make subject to inspection by the SEC) records and reports for each private fund they advise that include (i) the amount of assets under management and use of leverage, including off-balance-sheet leverage, (ii) counterparty credit risk exposure, (iii) trading and investment positions, (iv) valuation policies and practices of the fund, (v) types of assets held, (vi) side arrangements or side letters with investors and (vii) trading practices.
A registered adviser must maintain such records of private funds for such period or periods as the SEC prescribes by rule and may be required to file reports containing such information as the SEC determines by rule. A registered adviser’s private fund records are subject to periodic inspections and/or to be made available to the SEC. Further, the SEC may at any time conduct special and other examinations as the SEC determines is necessary and appropriate (including examinations of the records of persons having custody over an adviser’s clients’ assets) in the public interest and for the protection of investors, or for the assessment of systemic risk.
For Unregistered Advisers. As noted above, the Registration Act also provides that certain advisers that are exempt from registration will still be subject to new recordkeeping and SEC reporting requirements to be established by the SEC.
Information Sharing and Confidentiality. The Registration Act requires the SEC to make available to the Financial Stability Oversight Council (the “Council”) copies of all reports, documents, records and information filed with or provided to the SEC by an investment adviser as the Council requests. The Registration Act also expands the authority of the SEC to require any adviser “to disclose the identity, investments, or affairs of any client” as may be required for systemic risk assessment purposes (in addition to the existing inspection and enforcement purposes). The SEC and the Council are required to keep any such information received by them confidential (subject to limited exceptions related to disclosures required by law or to Congress or certain governmental agencies). Information provided to the SEC (or information provided by the SEC to the Council or any other government agency under the requirements of the Registration Act), is not subject to disclosure under the Freedom of Information Act.
General Requirements of a Registered Adviser under the Advisers Act
If an investment adviser is unable to fit within an existing exemption or one of the new exemptions referred to above, and is required to register with the SEC as an investment adviser, in general terms such adviser would be required to (i) file an annual Form ADV that would be publicly available and provided to clients, (ii) appoint a chief compliance officer, (iii) conform its business to the requirements of the Advisers Act and (iv) establish, implement and monitor written compliance policies and procedures reasonably designed to prevent violations of the Advisers Act and related regulations (including a code of ethics, insider trading policies, disaster recovery policies, etc.). In addition, an SEC registered investment adviser is subject to periodic examinations by the SEC staff.
The Definitions of “Client” and “Qualified Client”
The Registration Act clarifies the SEC’s ability to adopt rules defining terms used in the Advisers Act, provided that the SEC may not define the term “client” to include an investor in a private fund managed by an investment adviser that has entered into an advisory contract with that adviser.
The Registration Act provides that, for purposes of determining the dollar amount thresholds contained in the definition of “qualified client” in Rule 205-3 under the Advisers Act, no later than one year after the date of enactment of the Registration Act and every five years thereafter, the SEC is required to adjust such thresholds for the effects of inflation (rounded to the nearest $100,000). The principal effect of this amendment, once implemented, will be to raise the standard that investors in certain private funds must meet before the adviser may charge such funds and/or investors a carried interest or other performance fee.
Additional Registration Act Provision of Interest to Advisers to Private Funds – Updated “Accredited Investor” Standard
The Registration Act adjusts the net worth standard for an “accredited investor,” as set forth in Rule 501 promulgated under the Securities Act of 1933. Effective as of July 21, 2010, and for a period of four years thereafter, the individual net worth for any natural person (or joint net worth with such person’s spouse) must continue to be in excess of $1 million at the time of purchase, but such individual must exclude the value of his or her primary residence for purposes of determining whether he or she meets the $1 million net worth standard. During that four-year period, the SEC may review and adjust any other aspect of the definition of “accredited investor” as it applies to natural persons. On or after the fourth anniversary of the date of enactment, and not less frequently than once every four years thereafter, the SEC is required to review the definition of “accredited investor” in its entirety as it applies to natural persons to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest and in light of the economy.
Advisers should update the subscription agreements (and transfer agreements) for private investment funds to reflect the new definition of “accredited investor” and establish procedures for dealing with the new higher standards for both “accredited investors” and “qualified clients.” Advisers may need to refuse new investments from existing private fund investors that do not meet the new standards.
Additional Provisions of Interest Under the Dodd-Frank Wall Street Reform and Consumer Protection Act
Other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) will also affect investment advisers to certain private investment funds, particularly as rules are promulgated. For example:
- Advisers (particularly those within bank holding company organizations) may need to consider the effects of the Volcker Rule on their business, clients, fund investors and the industry.
- Certain private funds or advisers ultimately may be determined to be “nonbank financial companies” that are designated by the Council as “systemically important” and therefore subject to certain prudential standards and capital requirements and required to register with the Federal Reserve.
- The Act gives the SEC rulemaking authority to shorten the period for filing reports under Section 13(d) (5% ownership) and Section 16 (short swing profits) of the Securities Exchange Act of 1934 (the “1934 Act”) and the Act amends the reporting requirements of Section 13(d) and Section 13(f) (institutional investment managers) with respect to security-based swap agreements.
- The Act directs the SEC to adopt rules providing for at least monthly public disclosure of short sales by institutional investment managers under Section 13(f) of the 1934 Act, and the Act also makes unlawful a “manipulative short sale of any security” and directs the SEC to issue rules to ensure the availability of enforcement options and remedies for violations of this prohibition.
- The Act gives the SEC rulemaking authority regarding securities loans and requires it to issue rules designed to increase the transparency of information available to broker-dealers and investors with respect to securities loans.
- Advisers to private investment funds that trade derivatives should consider the impact of the Act (for example, registration, and numerous additional requirements, will be required for “swap dealers,” “security-based swap dealers,” “major swap participants” or “major security-based swap participants,” and advisers should review existing derivatives portfolios for compliance issues).
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Although it is unclear precisely how the SEC will utilize the broad authority granted to it under the Registration Act, it is clear that the landscape for investment advisers has changed. We will continue to monitor the progress of the Registration Act and any other related proposals and will advise on material developments. To discuss these matters further, or if we can assist in the assessment of your operations, the adoption and implementation of appropriate policies and procedures and/or the registration process, please contact your regular Goodwin Procter attorney.
David W. WatsonPartner
Paul J. VerbeseyPartner