The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted on July 21, 2010 (the "Act"), will have a substantial impact on the investment management industry. Among other things, it repeals the "private adviser" exemption from registration with the Securities and Exchange Commission (the "SEC") under the Investment Advisers Act of 1940 (the "Advisers Act") for private advisers with fewer than 15 clients.
Managers of hedge funds, private equity funds, and other private investment vehicles have historically relied upon the private adviser exemption, counting each managed fund as a separate "client." These advisers likely will be required to register with the SEC or be subject to state registration, depending on the amount of assets they have under management.
Also, the Act specifically defines a "private fund" to be a fund that relies upon either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 to avoid registration as an investment company under that act (a "Private Fund"). The Act subjects managers of Private Funds to certain record keeping and information reporting requirements, new rules, and SEC examination.
The Act does allow for a limited number of exemptions from Advisers Act registration or exclusions from the scope of the Advisers Act, as follows:
- Advisers Solely to Private Funds with Less than $150 Million of Assets under Management: The SEC is directed to provide an exemption from registration for these advisers, but they will be required to maintain such records and provide such reports to the SEC as the SEC may deem to be necessary in the public interest or for the protection of investors. The nature and scope of such records and reports are not set forth in the Act and will be addressed at a future date through the SEC's rule-making process.
- "Foreign Private Advisers": The Act exempts an adviser that (1) has no place of business in the United States; (2) has fewer than 15 U.S. clients and U.S. investors in Private Funds that it manages; (3) has less than $25 million (or more, as the SEC may determine) in assets under management attributable to such U.S. clients and U.S. investors; and (4) neither holds itself out to the public in the United States as an investment adviser, nor acts as an investment adviser to (a) any registered investment company or (b) any business development company.
- Advisers Solely to Venture Capital Funds: The Act exempts an adviser solely to venture capital funds from registration. The Act does not define "venture capital funds" but directs the SEC to prescribe such a definition by July 2011. Advisers who avail themselves of this exemption will be required to maintain such records and provide such reports to the SEC as the SEC, by future rulemaking, may deem to be necessary in the public interest or for the protection of investors.
- Advisers Solely to SBICs: The Act exempts advisers solely to small business investment companies ("SBIC's") licensed under the Small Business Investment Act of 1958 (other than entities that are regulated as business development companies).
- Certain Private Fund Advisers who are Registered with the CFTC: Private Fund advisers registered with the Commodity Futures Trading Commission ("CFTC") whose business is not "predominately the provision of securities-related advice" are exempt from registration under the Advisers Act.
- Certain Family Offices: Family offices are excluded from the definition of investment adviser. The Act directs the SEC to prescribe a definition of "family office" that is consistent with the SEC's previous, narrowly crafted exemptive orders for family offices, taking into account the "range of organization, management, and employment structures and arrangements employed by family offices."
- Certain "Intrastate" Advisers: This exemption covers "intrastate advisers" all of whose clients are residents of the state in which such investment adviser maintains its principal office and place of business, and who do not advise on exchange-traded securities. Advisers to Private Funds will now be excluded from this exemption.
Allocation of State and Federal Registration and Supervision
The Act adds a "mid-sized adviser" category to the
Advisers Act, transferring to and establishing state responsibility
for regulating advisers with more than $25 million but less than
$100 million of assets under management if such advisers have their
principal offices and places of business in a state that has
investment adviser registration and examination requirements. If
the state does not have registration and examination requirements,
the advisers will have to register with the SEC. Advisers with $100
million or greater assets under management will be required to
register with the SEC, unless otherwise exempt under the Act.
Advisers with assets under management of between $25 million and
$100 million that would be required to register with 15 or more
states may instead opt to register with the SEC. States that
regulate investment advisers (currently, all except for Wyoming)
will continue to be responsible for most smaller advisers with less
than $25 million of assets under management minimum for SEC
registration. For each category of adviser, the Act accords the SEC
authority to establish a higher dollar standard for federal
registration. The SEC retains authority to permit SEC registration
for advisers for which the state registration requirements would be
unfair, a burden on interstate commerce or otherwise inconsistent
with the purposes of the Advisers Act allocation of state and
federal responsibilities. There are existing rules that enable
certain pension consultants, multi-state and internet advisers to
register with the SEC on this basis.
While there is similarity in adviser regulation across many states,
registration criteria and post-registration regulation are not
uniform. In addition, as permitted under the Advisers Act, most
states require registration of individual "investment adviser
representatives" associated with both SEC and state-registered
advisers. Such registration is often predicated upon successful
passage of both the Series 7 and Series 65 exams, or the Series 66
exam, administered in each instance by the Financial Industry
Regulatory Authority, Inc., absent certain professional
designations (e.g., Chartered Financial Analyst).
Registration, Records and Reporting
Registration. An adviser registers with the SEC or a state by filing Part I of Uniform Form ADV electronically through the Investment Adviser Registration Depositary, maintained by FINRA. Part II of Form ADV operates as a disclosure form for clients and prospects and contains detailed information about the adviser's business, affiliates and control persons, personnel, fees, policies, conflicts of interest, and other information. While Part II of the Form ADV is currently maintained by advisers in paper, on July 21, 2010 the SEC voted to approve amendments that will require new narrative disclosure, electronic submission to the SEC and public access to such information through the SEC's website, effective January 1, 2011. State-registered advisers presently are often required to file Part II in paper with their state regulator, sometimes with additional information. SEC-registered advisers are required to designate a chief compliance officer and comply with Advisers Act rules on trading, codes of ethics, personal securities transactions, custody, performance fees, records, campaign contributions, and anti-fraud. Material events and certain changes to an advisers' business require prompt amendment of the Form ADV, and there is an annual updating amendment required within 90 days of fiscal year-end.
Additional Record-Keeping. The Act requires that SEC-registered investment advisers maintain the following information with respect to the Private Funds that they manage: the amount of assets under management, use of leverage (including off-balance-sheet leverage), counterparty credit risk exposure, trading and investment positions, valuation policies and practices of the fund, types of assets held, side arrangements or side letters, trading practices, and any other information that the SEC deems necessary. These data are in addition to existing record-keeping requirements. The Act also provides that the records and reports of a Private Fund managed by a SEC-registered investment adviser shall be deemed to be the records and reports of that adviser. All records are subject to SEC examination.
The Act also permits the SEC to require any SEC-registered investment adviser to maintain records and report information regarding Private Funds that the SEC determines to be in the public interest and necessary for the assessment of systemic risk by the new Financial Stability Oversight Council (the "FSOC"). The type or size of Private Funds may influence the reporting requirements. For example, the Act directs the SEC to take account of the size, governance and investment strategy of "mid-sized funds" (an undefined term) to determine whether they pose systemic risk and provide for registration and examination procedures that reflect the level of systemic risk posed by such funds.
Inspections. The Act provides that the SEC must conduct periodic inspections of the records of Private Funds that SEC-registered investment advisers maintain in accordance with a schedule that the SEC is to establish and allows the SEC discretion to conduct such additional examinations as it deems "necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk."
Confidentiality. Neither the SEC nor the FSOC can be compelled to disclose any information filed under the Act, except to Congress (upon agreement of confidentiality), in response to a request for information from another federal agency acting within its jurisdiction, or by court order. Sensitive, non-public information will remain confidential.
Adjusting "Qualified Client" Standards
Under the Advisers Act, an SEC-registered investment adviser may not enter into or perform an advisory contract with a client if such contract provides for compensation to the investment adviser on the basis of a share of capital gains upon, or capital appreciation of, all or any portion of client funds. This provision prevents a registered investment adviser from earning a so-called performance fee. The adviser is exempt from this prohibition, however, if its client meets the definition of a "qualified client." The net worth test for "qualified clients" is currently $1.5 million for natural persons, whether individually or together with a spouse. The Act provides that the SEC shall adjust this dollar amount to account for the effects of inflation in one year, and every five years thereafter.
Effective Date and Next Steps
The provisions of the Act affecting private investment advisers will become effective, generally, on July 22, 2011 (the "Effective Date").
This is a brief overview and does not cover all aspects of the Act. The SEC is expected to provide guidance and interpretation, in addition to the required rulemaking, but in the meantime all unregistered investment advisers should consider whether they will remain exempt under federal and state law, and SEC-registered advisers with assets under management of less than $100 million should evaluate whether they will be required to transfer from SEC to state registration and regulation prior to the Effective Date.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
