The New Regulatory Regime for Investment Advisers - Fund Management/ REITs

SEC Proposes Rules Defining Exemptions from Registration for Advisers to Venture Capital Funds, Advisers with Less than $150 Million in Assets Under Management and Non-US Advisers

Background

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act")¹, which, among other things, repealed the "private adviser" exemption from registration with the Securities and Exchange Commission ("SEC") under the Investment Advisers Act of 1940 (the "Advisers Act") for private advisers with fewer than 15 clients who neither hold themselves out to the public as investment advisers nor act as advisers to registered investment companies. Consequently, many previously unregistered advisers, particularly those to hedge funds and private equity funds, by next summer for the first time will have to register with either the SEC or applicable state securities authorities, depending upon the value of their assets under management, and become subject to regulatory oversight, rules and examination.

While repealing the private adviser exemption, the Dodd-Frank Act created several new exemptions from Advisers Act registration, including those for:

advisers solely to venture capital funds;
advisers solely to private funds with less than $150 million of assets under management in the United States; and
certain non-US advisers with no a place of business in the United States.

As required under the Dodd-Frank Act, the SEC has proposed new rules,² that, among other things, delineate the scope, terms and conditions of these exemptions.³

Venture Capital Funds

The Dodd-Frank Act provides for an exemption from registration for advisers solely to "venture capital funds", but it does not define "venture capital fund". Instead, it directs the SEC to prescribe a definition. Under the definition that the SEC has now proposed, a venture capital fund is a private fund that:

represents itself to investors as being a venture capital fund;
only invests in "equity securities" (as defined in the Securities Exchange Act of 1934) of private operating companies to provide primarily operating or business expansion capital (not to buy out other investors), US Treasury securities with a maturity of 60 days or less, or cash;
uses only limited leverage⁴, and its portfolio companies may not borrow in connection with the fund's investment (although they may borrow in the ordinary course of their business);
offers to provide a significant degree of managerial assistance to, or controls, its portfolio companies; and
does not offer redemption rights to its investors except in "extraordinary circumstances".

The proposed definition also includes a broad grandfathering provision that permits funds that have sold securities to one or more investors prior to December 31, 2010, that do not sell securities to, including accepting any additional capital contributions from, any persons after July 21, 2011, and that have represented themselves as venture capital funds to meet the proposed definition. The grandfathering provision expressly includes capital commitments made by investors prior to December 31, 2010 or July 21, 2011, as applicable, even if not called by such dates.

Private Fund Advisers with Less than $150 Million in Assets Under Management in the United States

The Dodd-Frank Act directs the SEC to provide an exemption from registration for investment advisers with less than $150 million in assets under management in the United States but is silent on how the $150 million is to be calculated. Proposed Advisers Act Rule 203(m) would extend this new exemption from registration to advisers to "private funds"⁵, provided the aggregate value of the adviser's private fund assets is less than $150 million.

New proposed Rule 203(m)-1 would require advisers to calculate the value of private fund assets by reference to Form ADV, under which the SEC proposes to provide a uniform method of calculating assets under management for regulatory purposes under the Advisers Act. The rule would require advisers to include assets appearing on the private fund's balance sheet as well as any uncalled capital commitments. An adviser could not, however, deduct liabilities, such as accrued fees and expenses or the amount of any borrowing. Each adviser would have to determine the amount of its private fund assets quarterly, based on the fair value of the assets at the end of the quarter, although such valuations would not be subject to reporting to the SEC. Once its assets under management in the United States exceeds $150 million, an adviser would have three months to register with the SEC under the Advisers Act.

In order to rely on the exemption for investment advisers with less than $150 million in assets under management, the SEC would require a US adviser to meet the conditions of the exemption with respect to all of its private fund assets under management, irrespective of whether or not it managed such assets in the United States. A non-US adviser only would be required to register to the extent that it manages $150 million of private fund assets from a place of business in the United States, and thus a non-US adviser would not need to include in the $150 million calculation assets that it manages outside the United States.

Non-US Advisers

The Dodd-Frank Act creates a new exemption from registration under the Advisers Act for "foreign private advisers". A foreign private adviser would be defined as any investment adviser that:

has no place of business in the United States;
has, in total, fewer than 15 US clients and private fund investors;
has aggregate assets under management attributable to US clients and private fund investors of less than $25 million; and
does not hold itself out generally to the public in the United States as an investment adviser.

The foreign private adviser exemption provides a much more limited exemption than the current private adviser exemption because it requires an adviser to count as clients the number of investors in funds that the adviser manages, rather than simply counting a fund as a single client. Therefore, under proposed Rule 202(a)(30)-1, an "investor" is defined as any person who would be included in determining the number of beneficial owners of the outstanding securities of a fund. In calculating the number of their clients, advisers would have to "look through" nominee and similar arrangements to the underlying holders of private fund securities to determine whether they have less than 15 clients — or private fund investors — in the United States. For example, an adviser to a master fund in a master-feeder arrangement would have to count as its investors any beneficial owner of securities of any feeder fund formed or generated for the purpose of investing in the master fund.

Reporting Requirements for Exempted Advisers

Although exempt from Advisers Act registration, under the proposal rules, advisers to venture capital firms and those advisers with less than $150 million in assets under management in the United States still would be required to file limited reports with the SEC, including basic information on the advisers' owners and affiliates, potential conflicts of interest, and any disciplinary history of principals and employees "that may reflect on their integrity". This information would be filed through the SEC's electronic filing system, or IARD, and would be publicly available on the SEC's website.

Reporting Requirements for Registered Advisers

The new rules would impose new SEC reporting obligations on registered advisers with respect to private funds that they advise. Under the proposed rules, registered advisers also would be required to provide:

basic organizational and operational information about the funds that they manage, such as information about the amount of assets that the fund holds, the types of investors in the fund, and the adviser's services to the fund;
identification of five categories of "gatekeepers" that perform critical roles for the private funds they manage (i.e., auditors, prime brokers, custodians, administrators and marketers); and
additional information about (a) the types of clients they advise, their employees and their advisory activities; (b) their business practices that may present significant conflicts of interest (such as the use of affiliated brokers, soft dollar arrangements and compensation for client referrals); and (c) their non-advisory activities and financial industry affiliations.

Pay-to-Play

The SEC also proposed to amend the investment adviser "pay-to-play" rule in response to changes made by the Dodd-Frank Act.⁶ Under the proposed amendment, an adviser would be permitted to pay a registered municipal advisor, instead of a "regulated person", to solicit governmental entities on its behalf if the municipal advisor is subject to a pay-to-play rule adopted by the Municipal Securities Rulemaking Board (the "MSRB") that is at least as stringent as the investment adviser pay-to-play rule. The MSRB received new authority over municipal advisors under the Dodd-Frank Act.

Comment Period and Next Steps

In statements made at the SEC's open meeting on November 19, 2010 in which the SEC voted to propose the rules, SEC Chair Mary Schapiro affirmed her intention to finalize the rules in advance of the Dodd-Frank Act registration effective date of July 21, 2011 to give clarity to advisers seeking to determine their registration status. The SEC has requested comment on a range of issues and questions, and it is possible that the comments will result in more advisers being able to fit under the final exemptions. Thus, ineligible advisers either will have to register as investment advisers on or before July 21, 2011, or revise their operating models to come within the new exemptions. Registered advisers to private funds also are likely to have additional disclosure obligations with respect to such funds. As a result, all investment advisers to private funds will need to evaluate their circumstances carefully in light of the rule proposals.

Comments to the proposals are due by January 24, 2011.

The following lawyers contributed to this publication: Paul Gajer, Mike McNamara, Ira Roxland, Walter Van Dorn, Sara Werner, and Mike Zolandz.

Footnotes

1. The Dodd-Frank Wall Street Reform and Consumer Protection Act. Title IV, Section 409, Pub.L. No. 111-203, 124 Stat.1376 (2010).

2. Investment Advisers Act Rel. No. 3110 (Nov. 19, 2010), www.sec.gov/rules/proposed/2010/ia-3110.pdf; Investment Advisers Act Rel. No. 3111 (Nov. 19, 2010), www.sec.gov/rules/proposed/2010/ia-3111.pdf.

3. The Dodd-Frank Act also amended the Advisers Act to exclude a "family office" from the definition of "investment adviser" in the Advisers Act, as discussed in further detail in our November 12, 2010 Client Alert, which can be found here.

4. Under proposed Advisers Act Rule 203(l)-1, the definition of venture capital fund for purposes of the exemption would be limited to a private fund that does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of its capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days.

5. Section 202(a)(29) of the Advisers Act defines the term "private fund" as "an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of that Act".

6. Also see our September 10, 2010 client alert on new requirements to prevent "pay to play" relationships between investment advisers and elected officials who control or influence the awarding of investment advisory business, which can be found here.

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.

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