Alert June 28, 2011

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

The SEC issued final rule and form changes (the “Implementing Amendments”) that will (a) require advisers who are exempt from registration under the new exemptions from adviser registration created by the Dodd-Frank Act for advisers to venture capital funds and advisers to private funds with less than $150 million in assets under management, as discussed in the July 23, 2010 Goodwin Procter Alert (collectively, “Exempt Reporting Advisers”), to file certain information with the SEC, and (b) give effect to other provisions of the Dodd‑Frank Act.  Although the Implementing Amendments focus to a significant extent on Exempt Reporting Advisers, the changes they make to Form ADV Part 1A also apply to registered investment advisers, and set forth new, detailed reporting requirements regarding private funds managed by registered investment advisers.  This article provides an overview of the principal changes to Form ADV under the Implementing Amendments.  The Implementing Amendments also include amendments to Rule 206(4)‑5, the so‑called “pay to play” rule, which was adopted in July 2010 (as discussed in the July 9, 2010 Goodwin Procter Client Alert) and is not fully effective; these amendments (1) make Exempt Reporting Advisers subject to the rule, (2) create an additional exception to allow payments to a registered municipal advisor for soliciting a government entity, subject to certain conditions, and (3) push back the compliance date for the Rule’s provision limiting payment for third-party solicitation of government entities from September 30, 2011 to June 13, 2012.

Calculating Assets Under Management

The Implementing Amendments create the defined term “regulatory assets under management,” which is used to determine whether an adviser is eligible to be registered with the SEC.  Regulatory assets under management include all “securities portfolios” (i.e., the total value of each portfolio at least 50% of whose 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).  In calculating this amount, an adviser must include proprietary assets, assets managed without receiving compensation, and assets of foreign clients in the regulatory assets under management calculation; currently an adviser may, but is not required to, include these amounts in calculating its assets under management for Form ADV Part 1A.  Regulatory assets under management also include the value of any private fund over which an adviser exercises continuous and regular supervisory or management services regardless of the nature of the assets held by the fund.  (The Implementing Amendments 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 will require advisers to use the market value, or the fair value if market value is unavailable, (not cost) of private fund assets in determining their regulatory assets under management.  The Implementing Amendments do not mandate the use of GAAP or any other accounting standard.

Private Fund Reporting

The Implementing Amendments significantly increase the amount of information that an adviser is required to report on its private funds under Item 7.B. of Form ADV Part 1A.  These amendments in part, reinstate Form ADV Part 1A amendments that the SEC adopted in 2004 as part of its “hedge fund adviser registration” rulemaking, but which were vacated by the 2006 decision in Goldstein v. Securities and Exchange Commission

Under the Implementing Amendments, the SEC will no longer require an adviser to report funds that are advised by affiliates, and will allow a sub-adviser to exclude private funds for which an adviser is already reporting on Schedule D to Form ADV Part 1A.  In addition, an adviser sponsoring a master‑feeder arrangement may 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 1A will 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 will also need to provide information about its regulatory status and the regulatory status of the fund, 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 will be required to disclose the fund’s gross assets and 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 will be required to identify by name and SEC file number any other advisers to the fund.  The SEC chose not to adopt amendments that would require an adviser to (a) disclose a private fund’s net assets; (b) report private fund assets and liabilities by class and categorization in the fair market hierarchy established under GAAP; and (c) provide the percentage of each private fund owned by specified types of beneficial owners (e.g., individuals, broker-dealers, pension plans, state and local governments).  This information may nevertheless ultimately be required in reports to the SEC and Financial Stability Oversight Council on Form PF.  (The SEC and CFTC’s proposal regarding Form PF was discussed in the February 1, 2011 Alert.)  Finally, an adviser must 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 will 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 must identify each of these service providers, provide their locations, and state whether they are related persons.  Form ADV will 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 PCAOB and subject to its regular inspection, whether audited statements are distributed to fund investors, and whether the auditor’s report contains an unqualified opinion.
  • Prime Brokers: whether they are SEC-registered and whether they act as custodian for private fund assets. 
  • 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 a person, such as an administrator, 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 Implementing Amendments revise Item 5 of Form ADV Part 1A, which requires an adviser to provide basic information regarding its business, including the types of services it provides, and clients.  Among other things, the Implementing Amendments 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 calculation 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 must provide that investment company’s SEC file number under the 1940 Act, which will 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 Implementing Amendments expand the range of other financial services that if provided by an adviser or one of its affiliates must be identified in both Items 6 and 7 of Form ADV Part 1A to also include acting as 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 created by the Dodd-Frank Act. The Implementing Amendments also require additional reporting in the corresponding sections of Schedule D, which will entail 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 personnel or the same physical location.  

In response to public comment, the SEC scaled back the Schedule D disclosure requirements from those it had originally proposed so that an adviser will be able omit disclosure for a related person if:

(1) the adviser and related person have no business dealings related to the adviser’s advisory business;

(2) the adviser and related person do not conduct shared operations;

(3) the adviser and related person do not refer clients or business to each other;

(4) the adviser does not share its supervised persons or premises with the related person; and

(5) the adviser has no reason to believe that its relationship with the related person otherwise creates a conflict of interest with its clients.

The adopting release provides the following examples of how these conditions will apply: an adviser may omit Schedule D disclosure for (a) an offshore adviser with which the adviser has no business dealings; (b) a bank that merely provides it with payroll services; (c) an accounting firm that prepares the adviser’s annual tax return filings; or (d) a real estate broker that represents the adviser in securing office space; but an adviser may not omit an affiliated adviser with whom the adviser shares information technology  infrastructure, which would be considered sharing operations.

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 Implementing Amendments require additional disclosure as to whether any of the recommended brokers or dealers are related persons of the adviser.  In addition, an adviser that indicates that it receives “soft dollar benefits” must 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, an adviser must indicate whether it or any of its related persons receives compensation for client referrals.

Reporting $1 Billion in Balance Sheet Assets

Pursuant to Section 956 of the Dodd-Frank Act, the SEC and certain other federal regulators have proposed a joint rule that addresses 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.  (See the March 8, 2011 Alert for a discussion of the proposed rule.)  Under the Implementing Amendments each adviser must indicate in Item 1 of Form ADV Part 1A whether or not the adviser had $1 billion or more in assets on its balance sheet as of the last day of the adviser’s most recent fiscal year. 

Compliance Date for Form ADV Changes

The SEC currently anticipates that beginning in November 2011 the IARD, which receives electronic filings on Form ADV, will have been re-programmed to accept the changes to Form ADV adopted in the Implementing Amendments.  After January 1, 2012, any adviser filing an amendment to Form ADV will be required to provide responses to revised Form ADV.  As part of the transition process for Dodd-Frank Act related changes to Advisers Act exemptions, all advisers registered on January 1, 2012, regardless of their fiscal year end, will be required to file an amendment to their Form ADV on revised Form ADV by March 30, 2012.  An investment adviser filing an initial application for registration after the IARD is re-programmed to accommodate filing of the revised Form ADV must complete the revised form.