The Dodd-Frank Act, among other things, repealed §203(b)(3) of the Investment Advisers Act of 1940 (the “Advisers Act”) exempting an investment adviser with fewer than 15 clients in the preceding 12 months from registration. The primary purpose of the repeal was to require registration of advisers to Private Funds. Private Funds mean hedge funds, private equity funds and other types of pooled investment vehicles excluded from the definition of “investment company” under the Investment Company Act of 1940 (the “Investment Company Act”) by reason of §§ 3(c)(1) or 3(c)(7) thereof. The former pertains to a fund that has no more than 100 beneficial owners of its outstanding securities and the latter pertains to a fund the outstanding securities of which are owned by “qualified purchasers.” Each Private Fund typically had qualified as a single client for purposes of Advisers Act §203(b)(3) and, as a result, an investment adviser could advise up to 14 Private Funds regardless of the total number of investors in those funds without the need to register under the Advisers Act.
To address certain considerations arising from repeal of the fewer-than-15 client exemption, Dodd-Frank created new exemptions1 for:
- an investment adviser that advises solely venture capital funds;2
- an investment adviser that advises solely Private Funds if the adviser has assets under management in the U.S. of less than $150 million;3
- a family office;4 and
- certain foreign private advisers.5
As in the case of many Dodd-Frank provisions, implementation of the new exemptions is dependent upon regulatory action, in this case by the SEC. This Advisory summarizes the SEC’s recent actions in this regard.6
Venture Capital Funds
Effective July 21, 2011, the SEC adopted Rule 203(l)-1 defining the term “venture capital fund” and, thus, implementing Advisers Act §203(l). It is important to note that the term is rather narrowly defined in order to distinguish venture capital funds from other types of Private Funds, such as hedge funds, private equity funds and leveraged buyout funds, and to address concerns expressed by Congress regarding the potential for systemic risk.
To be able to rely upon the Rule, an investment adviser must advise solely venture capital funds. In summary, the Rule defines a venture capital fund as a Private Fund that:
- holds no more than 20% of the fund’s capital contributions and uncalled committed capital in non-qualifying investments (other than short-term holdings) valued at cost or fair value, consistently applied. “Qualifying investments” generally consist of equity securities of “qualifying portfolio companies” 7 that are directly acquired by the fund from such companies;
- does not borrow or otherwise incur leverage, other than limited short-term leverage (excluding certain guarantees by the fund of qualifying portfolio company obligations);
- does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances;
- represents itself to its investors and prospective investors as pursuing a venture capital strategy; an
- is not registered under the Investment Company Act and has not elected to be treated as a business development company thereunder.
Newly-adopted Rule 203(l)-1 also grandfathers a pre-existing fund as a venture capital fund if it satisfies certain criteria.8
Small Private Funds
Effective July 21, 2011, the SEC also adopted Rule 203(m)-1 which provides that an investment adviser with its principal office and place of business in the U.S. is exempt from Advisers Act registration if the investment adviser:
- acts solely as an investment adviser to one or more “qualifying private funds;” and
- manages Private Fund assets of less than $150 million.9
A “qualifying private fund” means any Private Fund that is not registered under §8 of the Investment Company Act and has not elected to be treated as a business development company thereunder. An investment adviser may treat as a Private Fund any issuer that qualifies for exclusion from the definition of “investment company” in §3 of the Investment Company Act in addition to the exclusions provided for in §§3(c)(1) and 3(c)(7) provided that the investment adviser treats such issuer as a Private Fund under the Advisers Act and the rules thereunder for all purposes. Funds in addition to those covered by Investment Company Act §§3(c)(1) or 3(c) (7) include certain types of real estate funds, oil and gas-related funds, certain charitable funds and certain trusts associated with employee benefit plans. However, this does not mean, for example, that a fund solely relying on the §3(c)(5)(C) exclusion for real estate funds may be treated as a Private Fund. Instead, it means that such a fund which is relying on both §§3(c)(1) or 3(c)(7) and §3(c)(5)(C) may be deemed a Private Fund.
Private fund assets, for purposes of the $150 million test, which are to be calculated annually, mean the investment adviser’s assets under management attributable to qualifying private funds. The calculation of assets under management for this purpose must include proprietary assets and assets managed without compensation as well as uncalled capital commitments. In addition, the investment adviser must determine the amount of its private fund assets based on market value, or fair value where market value is unavailable, and must calculate the assets on a gross basis (i.e., without deducting liabilities, such as accrued fees and expenses and the amount of any borrowing).
Exempt Reporting Advisers
Notwithstanding the foregoing two exemptions from registration, Advisers Act §§ 203(l) and 203(m) provide that the SEC shall require the exempt advisers to maintain such records and submit such reports as the SEC determines necessary or appropriate. Effective September 17, 2011, the SEC adopted Advisers Act Rule 204-4 requiring that such advisers file reports on Form ADV. 10 Form ADV is utilized by all persons registering with the SEC as an investment adviser and all persons who already are so registered. Exempt reporting advisers are required to complete a subset of the items on such Form and the information provided thereby will be made available to the public. In addition, exempt reporting advisers are subject to examination by the SEC. In the Release adopting Rule 204-4 11 the SEC stated that it does not anticipate that its Staff will conduct compliance examinations of exempt reporting advisers on a regular basis but that the Staff will conduct cause examinations when there are indications of wrongdoing. 12
Effective August 28, 2011, the SEC adopted Rule 202(a)(11)(G)-1 defining the term “family office” and, thus, implementing Advisers Act §202(a)(11) (G). A family office, as so defined, is excluded from the Act’s definition of “investment adviser” and thus is not subject to any of the provisions of such Act.13 The Rule contains three general conditions. First, the exclusion is limited to family offices that provide advice about securities only to certain “family clients.” Second, it requires that family clients wholly own the family office and “family members” and/or family entities control the family office. Third, it precludes a family office from holding itself out to the public as an investment adviser. The rule also contains grandfathering provisions.
“Family clients” include current and former “family members,” key employees of the family office (and, under certain circumstances, former key employees), charities funded exclusively by family clients, estates of current and former family members or key employees, trusts existing for the sole current benefit of family clients or, if both family clients and charitable and non-profit organizations are the sole current beneficiaries, trusts funded solely by family clients, revocable trusts funded solely by family clients, certain key employee trusts, and companies wholly owned exclusively by, and operated for the sole benefit of, family clients (with certain exceptions).
A “family member” means all lineal descendants of a common ancestor (who may be living or deceased) as well as current and former spouses and spousal equivalents of those descendants, provided that the common ancestor is no more than 10 generations removed from the youngest generation of family members. Children by adoption, stepchildren, foster children and an individual that was a minor when another family member became a legal guardian of that individual are considered “family members.” A family has the right to choose a common ancestor and define family members by reference to the degree of lineal kinship to the designated relative subject to the 10 generation limitation between the oldest and youngest generation of family members. Such designation may be changed over time so that the family office clientele is able to shift over time along with the family members served by the family office. It should be noted that the exclusion of a family office from Advisers Act coverage does not extend to an office serving multiple families.
With respect to grandfathering, the Rule provides that a company engaged in the business of providing investment advice primarily to members of a single family on July 21, 2011 and that is not registered under the Advisers Act in reliance on the fewer-than-15 client exception on July 20, 2011 is exempt from registration as an investment adviser until March 30, 2012 provided that it neither holds itself out generally to the public as investment adviser nor acts as an investment adviser to an investment company registered under the Investment Company Act or a company which has elected to be a business development company thereunder and has not withdrawn its election and, in addition, the company in the course of the preceding 12 months has had fewer than 15 clients. The Rule also contains a Dodd-Frank-mandated grandfathering provision for certain other family offices. 14
Foreign Private Advisers
The Dodd-Frank Act replaced previously existing Advisers Act §203(b)(3) with a new provision having that designation that provides an exclusion from registration for any investment adviser that is a “foreign private adviser” and added new §202(a)(30) defining that term. As so defined, the exclusion applies to any investment adviser who:
- has no place of business in the U.S.;
- has, in total, fewer than 15 clients in the U.S. and investors in the U.S. in Private Funds (as defined on page 1 hereof) advised by the investment adviser;
- has aggregate assets under management attributable to clients in the U.S. and investors in the U.S. in Private Funds advised by the investment adviser of less than $25 million or such higher amount as the SEC may determine; and
- does not hold itself out generally to the public in the U.S. as an investment adviser nor act as an investment adviser to an investment company registered under the Investment Company Act or that has elected to be a business development company thereunder and has not withdrawn its election.
Effective July 21, 2011, the SEC adopted Rule 202(a) (30)-1 defining certain terms used in the foreign private adviser exclusion including “investor,” “in the United States,” “place of business” and “assets under management.” The Rule also includes the safe harbor and many of the client counting rules that appeared in former Advisers Act Rule 203(b)(3)-1. A detailed discussion of the foreign private adviser exclusion is beyond the scope of this Advisory.
Qualified Client Dollar Tests
Advisers Act Rule 205-3 exempts a registered investment adviser from the prohibition against charging performance fees in certain circumstances, including when the client is a “qualified client.” The Rule allows an investment adviser to charge performance fees if the client has at least $750,000 under the management of the investment adviser immediately after entering into the advisory contract (the “Assets Under Management Test”) or if the investment adviser reasonably believes that the client has a net worth of more than $1,500,000 at the time the contract is entered into (the “Net Worth Test.”)
The Dodd-Frank Act amended Advisers Act §205(e) to provide that, by July 11, 2011 and every 5 years thereafter, the SEC shall adjust the foregoing dollar amount tests for inflation. 15 Pursuant to an Order issued July 12, 201116 the SEC has increased the Assets Under Management Test to $1,000,000 and the Net Worth Test to $2,000,000 effective as of September 19, 2011.