Alert December 07, 2010

SEC Proposes Amendments to Form ADV and Changes to “Pay-to-Play” Regulations in Connection with Dodd-Frank Act Implementation

The SEC issued proposed rules and rule amendments (the “Implementing Rules”) that would (a) require advisers who are exempt from registration under either the Venture Capital Exemption or the Private Fund Adviser Exemption, as discussed in recent Goodwin Procter Alerts (“Exempt Reporting Advisers”), to file certain information with the SEC, and (b) give effect to other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).  Although the Implementing Rules focus to a significant extent on Exempt Reporting Advisers, the proposed changes to Form ADV Part 1A would apply to all investment advisers, and set forth new, detailed reporting requirements focused on private funds managed by registered investment advisers.  The Implementing Rules also include proposed amendments to Rule 206(4)-5, which was adopted in July 2010 (as discussed in the July 9, 2010 Goodwin Procter Client Alert) and is not fully effective, which are designed to (1) ensure that Exempt Reporting Advisers remain subject to the rule, (2) allow payments to a “regulated municipal adviser” in accordance with the rules of the Municipal Securities Rulemaking Board and (3) clarify the definition of “covered associate” to include entities such as general partners.

Calculation of Assets Under Management

The SEC proposes to create a defined term “regulatory assets under management,” which would be used to determine whether an adviser is eligible to be registered with the SEC.  Specifically, regulatory assets under management would include all “securities portfolios” (i.e., the total value of a portfolio if at least 50% of its total value consists of securities) for which an adviser provides continuous and regular supervisory or management services (without any deduction for leverage or other accrued but unpaid liabilities but including uncalled capital commitments).  An adviser would be required to include proprietary assets, assets managed without receiving compensation, and assets of foreign clients in the regulatory assets under management calculation, all of which an adviser currently may, but is not required to, include in calculating assets under management in current Form ADV Part 1A. The SEC is proposing to require advisers to use the fair value (not the cost) of private fund assets in determining their regulatory assets under management.  (The Implementing Rules would define “private fund” as an investment company that relies on the exclusion in Section 3(c)(1) or 3(c)(7) under the Investment Company Act of 1940 (the “1940 Act”).) The SEC specifically noted that it is not proposing to require advisers to determine fair value in accordance with GAAP, but did request comments as to whether it should require the use of GAAP. 

Private Fund Reporting

The SEC is proposing extensive amendments to the information that an adviser is required to report on its private funds under Item 7.B. of Form ADV Part 1A.  These amendments would, in part, re-instate the Form ADV Part 1A amendments that the SEC adopted in 2004 as part of its “hedge fund adviser registration” rulemaking, but which were vacated in connection with the 2006 decision in Goldstein v. Securities and Exchange Commission

Under the proposed amendments, the SEC would no longer require an adviser to report funds that are advised by affiliates, and would allow a sub-adviser to exclude private funds for which an adviser is reporting on another Schedule D.  In addition, an adviser sponsoring a master‑feeder arrangement could submit information on an aggregate basis for the master fund and all of the feeder funds that would otherwise be submitting substantially identical data.

Section 7.B.1.A. of Schedule D to Form ADV Part IA would require identifying information for each private fund, including the fund’s name, as well as the state or country where the fund was organized, and the name of its general partner, directors, trustees or persons occupying similar positions.  The adviser would also need to provide information about the regulatory status of the fund and its adviser, including the exclusion from the 1940 Act on which the fund relies, whether the adviser is subject to a foreign regulatory authority, and whether in offering its securities the fund relies on an exemption from registration under the Securities Act of 1933. 

The adviser would also be required to disclose the size of the fund, including both its gross and net assets, and the extent of leverage it employs.  In addition, the adviser would be required to identify in which of the following categories the fund falls based on its investment strategy: (i) hedge fund; (ii) liquidity fund; (iii) private equity fund; (iv) real estate fund; (v) securitized asset fund; (vi) venture capital fund; or (vii) other private fund.   An adviser that is a sub-adviser to a private fund would be required to identify by name and SEC file number any other advisers to the fund.  An adviser would further be required to break down the assets and liabilities held by a private fund by class and categorization in the fair value hierarchy established under GAAP.   Finally, an adviser would be required to disclose the number and the types of investors in a private fund, as well as the minimum amounts required to be invested by fund investors. 

Information Regarding Service Providers

Section 7.B.1.B. of Schedule D to Form ADV Part 1A would require an adviser to provide information regarding five types of service providers that the SEC perceives as “gatekeepers” for private funds: auditors, prime brokers, custodians, administrators and marketers.  For each private fund, an adviser would have to identify each of these service providers, provide their locations, and state whether they are related persons.  The SEC would require specific information for each service provider regarding its services and registration status, including the following:

  • Auditors: whether the they are independent, registered with the Public Company Accounting Oversight Board (PCAOB) and subject to its regular inspection, and whether audited statements are distributed to fund investors.
  • Prime Brokers: whether they are SEC-registered and whether they act as custodian for the private fund. 
  • Custodians: whether they are related persons of the adviser. 
  • Administrators: whether they prepare and send account statements to fund investors and what percentage of the fund assets are valued by the administrator or another person that is not a related person of the adviser. 
  • Marketers: whether they are related persons of the adviser, their SEC file number (if any), and the address of any website they use to market the fund.

Information about an Adviser’s Business

The SEC is also proposing to revise Item 5 of Form ADV Part 1A, which requires an adviser to provide basic information regarding the adviser’s business, including its services, and clients.

The SEC proposes to expand the list of client types and require an adviser to provide the approximate amount of assets under management attributable to each client type using the new regulatory assets under management determination and state the approximate percentage of its clients that are not United States persons.  An adviser that discloses that it has a registered investment company client would be required to provide that investment company’s SEC file number under the 1940 Act, which would enable SEC examination staff to cross check Form ADV disclosures against corresponding disclosures in investment company filings.

Other Business Activities and Financial Industry Affiliations

The SEC is proposing to expand the range of financial industry affiliates to be identified in both Items 6 and 7 of Form ADV Part 1A to include affiliations with a trust company, registered municipal advisor, registered security-based swap dealer, and major security-based swap participant, the latter three of which are new SEC-registrants as a result of the Dodd-Frank Act.  The SEC is also proposing to require additional reporting in the corresponding sections of Schedule D, which would include disclosure relating to the use of other business names and identifying information for each related person listed in Item 7.A., including more details about the relationship between the adviser and the related person, whether the related person is registered with a foreign financial regulatory authority, and whether the adviser and related person share certain kinds of non-public information or personnel with access to that information.  The SEC stated that this additional information would allow it to link disparate pieces of information concerning an adviser and its affiliates and to identify whether the adviser controls the related person or vice versa.  The SEC also noted that the additional information would provide it with a tool to identify advisory activities by unregistered affiliates.

Participation in Client Transactions

Under Item 8 of Form ADV Part 1A an adviser is required to indicate if it has discretionary authority to determine the brokers or dealers for client transactions and if it recommends brokers or dealers to clients.  The SEC proposes requiring additional disclosure as to whether any of the brokers or dealers are related persons of the adviser.  In addition, an adviser that indicates that it receives “soft dollar benefits” would also report whether all those benefits qualify for the safe harbor under Section 28(e) of the Securities Exchange Act of 1934 for eligible research or brokerage services.  Finally, the SEC is proposing to add a new question requiring an adviser to indicate whether it or any of its related persons receives compensation for client referrals, which is designed to complement the existing question concerning whether an adviser compensates any person for client referrals.

Reporting $1 Billion in Balance Sheet Assets

Section 956 of the Dodd-Frank Act requires the SEC and certain other federal regulators, to adopt rules or guidelines addressing certain excessive incentive-based compensation arrangements, including those of any registered investment adviser with $1 billion or more in assets on its own balance sheet.  In anticipation of rulemaking related to that mandate, the SEC is proposing to require each adviser to indicate in Item 1 of Form ADV Part 1A whether or not the adviser had $1 billion or more in assets as of the last day of the adviser’s most recent fiscal year.  For these purposes, an adviser’s total assets would be determined in the same manner as the amount of “total assets” is determined on the adviser’s balance sheet for its most recent fiscal year end.

Public Comments

Comments on the proposed rules are due within 45 days of publication in the Federal Register.