The US House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009 (the “House Bill”) on December 11, 2009. More recently, on March 15, 2010, Senate Banking Committee Chairman Christopher Dodd introduced an updated draft of his financial reform legislation, titled the Restoring American Financial Stability Act of 2010 (the “Dodd Bill”). Portions of the House Bill and the Dodd Bill relate to managers/advisers to private funds (“Private Fund Advisers”).1 This article provides a summary of the potential impact of the House Bill and the Dodd Bill on Private Fund Advisers if either is passed into law.
Under current law, many Private Fund Advisers rely on the “private adviser” exemption under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), and are not required to register with the SEC. Generally, the “private adviser” exemption exempts from registration any Private Fund Adviser that has had fewer than 15 clients (with each fund counting as one client) in the preceding 12-month period. Both the House Bill and the Dodd Bill would eliminate the private adviser exemption and require many investment advisers that are currently exempt from registration to register as investment advisers under the Advisers Act.
Registration Requirements Under the House Bill and the Dodd Bill
Under both the House Bill and the Dodd Bill, the requirement to register with the SEC would apply to all investment advisers to any “private fund.” Generally, a “private fund” is defined as a company that would be an investment company but for certain exceptions contained in the Investment Company Act of 1940.
While both the House Bill and the Dodd Bill would eliminate the private adviser exemption, there are differences between the bills in other areas, including the exceptions to the registration requirement. Generally, the following categories of Private Fund Advisers would be exempt from registration in each case as noted:
- Advisers to Smaller Funds. Advisers to private funds with less than $150 million in assets under management are not required to register under the House Bill. The Dodd Bill does not provide an exemption based on the size of a fund being advised, but does have an exemption for advisers that have less than $100 million of assets under management across all funds.
- Venture Capital Fund Advisers and Private Equity Fund Advisers. Advisers to venture capital funds would also be exempt from registration per both the House Bill and the Dodd Bill. The term “venture capital fund” is not defined under either bill, with the responsibility for defining this term left to the SEC. The Dodd Bill goes further and also exempts advisers to “private equity funds” from registration and requires the SEC to define that term as well. While the House Bill requires the SEC to impose special reporting and recordkeeping obligations on venture capital funds, the Dodd Bill does not, but instead requires that the SEC issue final rules to require private equity fund advisers to maintain such records and reports as the SEC determines are necessary and appropriate.
- Advisers to Family Offices. The Dodd Bill, but not the House Bill, provides a new exclusion from the definition of “investment adviser” under the Advisers Act for a “family office,” another term to be defined by the SEC.
- Small Business Investment Company Advisers. Under both the House Bill and the Dodd Bill, private advisers to SBICs regulated by the Small Business Administration are exempt from registration.
- Foreign Private Advisers. Finally, both bills exempt foreign private advisers. In general, to qualify as a “foreign private adviser,” an adviser must have no place of business in the United States, have fewer than 15 clients in the United States, manage less than $25 million in assets attributable to clients in the United States and not hold itself out to the public in the United States as an investment adviser.
How Might This Legislation Affect You?
Likely to be Some Impact, but Specifics Are Yet to be Determined. The House Bill is not law, as it has just been passed in the House. The Dodd Bill is the Senate’s version of this legislation and, if passed by the Senate, the differences between the House and Senate versions will require some ironing out. Obviously, knowing which and how Private Fund Advisers will be impacted depends on the legislation that Congress ultimately passes. While there is some uncertainty as to the final content of the legislation that may be enacted, at a minimum, many advisers are likely to be subject to additional reporting obligations.
Private Fund Advisers May be Required to Register. If either bill is passed by Congress in its current form, the private adviser exemption traditionally relied upon will be eliminated and many private advisers that are currently exempt will be required to register with the SEC.
Once registered, a Private Fund Adviser will be subject to additional provisions of the Advisers Act. While registration will lead to additional obligations and the incurrence of additional costs, most managers should be able to comply with the Advisers Act without significant implications on their business.
The way the SEC defines the terms “private equity funds” and “venture capital funds” will have farreaching implications. For example, it is unclear whether a Private Fund Adviser to a distressed, real estate, mezzanine, fund-of-funds, or other closed-end fund would fit within the exceptions. Depending on the way “private equity fund” is defined, certain private equity funds with more than 15 clients that are currently registered may no longer be required to register. We suspect putting contours around these definitions will be no easy task in light of the historical difficulty the SEC has had in trying to limit registration to hedge funds and exempt private equity funds under prior legislation.
The following is a short, non-exhaustive list of the practical effects registration could have on a Private Fund Adviser:
- Registration on Form ADV. Registered investment advisers must file a Form ADV with the SEC and keep it current by filing periodic amendments, including an annual amendment on Schedule I to Form ADV.
- Prohibition on Performance Fees from Non- Qualified Clients. In general, the Advisers Act only permits private advisers to receive straight performance-based compensation (e.g., carried interest) from (i) qualified purchaser (QP) funds, (ii) business development companies, (iii) non-U.S. persons, or (iv) “qualified clients” (generally persons with at least $750,000 in assets under management with the private adviser or a $1.5 million net worth). This prohibition on performance-based compensation would be problematic for private advisers to non-QP Funds with investors that are not “qualified clients.” It is unclear how the new legislation would deal with this issue.
- Compliance Program, Recordkeeping Requirements and Audits. The Advisers Act imposes certain compliance and recordkeeping requirements on private advisers, including requirements that they must:
- adopt compliance policies and procedures and maintain books and records;
- appoint a chief compliance officer;
- make and maintain filings with the SEC; and
- maintain certain records and make them available to the SEC upon request.
Registered advisers would also be subject to periodic SEC audits.
In addition to the current disclosure requirements under the Advisers Act, both the House Bill and the Dodd Bill authorize the SEC to require private advisers to maintain records and submit reports that are determined to be “necessary or appropriate in the public interest for the protection of investors or for the assessment of systemic risk.” Under both bills, a private adviser would have to make a report with respect to each private fund it advises, disclosing:
- the fund’s assets under management;
- use of leverage (including off-balance sheet leverage);
- counterparty credit risk exposure;
- trading and investment positions and trading practices; and
- other information that the SEC determines necessary or appropriate to, among other things, the assessment of systemic risk.
In addition to the above, the Dodd Bill would also require a description of:
- valuation policies and practices of the fund;
- the types of assets held; and
- side letters entered into with fund investors.
Custody Rules/Surprise Audits. Registered investment advisers are subject to the custody rule of the Advisers Act. Among other things, the custody rule requires registered investment advisers with custody of client funds or securities to maintain them with a “qualified custodian” and contain quarterly client account statements and annual surprise examination requirements. The surprise examination requirement is an examination by an independent accountant to verify the existence of client securities and funds. The surprise examination is not required if a Private Fund Adviser delivers audited financial statements (prepared in accordance with GAAP) to investors within 120 days (180 days for a fundof- funds) of the fund’s fiscal year end.
In summary, both the House Bill and the Dodd Bill would eliminate the private adviser exemption under the Advisers Act and require certain Private Fund Advisers to register with the SEC. We note that the Department of Treasury’s June 17, 2009 White Paper on Financial Regulatory Reform emphasized the role that highly leveraged hedge funds played in the financial crisis and stated that registration of these types of funds would allow regulators to monitor their market activity. However, the current regulatory efforts are overbroad in that they do not focus on the types of hedge funds that pose significant risks to the financial markets. The SEC could limit the reach of the proposed registration requirements in how they define “private equity funds” and “venture capital funds.” However, since there is no bright line distinction between a hedge fund, a private equity fund, or venture capital fund, the SEC will likely have a very difficult time establishing definitions as required under the House Bill and the Dodd Bill. Due to this definitional difficulty, there is a risk that the SEC will err on the side of being over-inclusive, thereby requiring more adviser registration than it should or Congress intended.
Requiring the registration of many additional private advisers under the Advisers Act would be both costly and burdensome not only to advisers but also to the SEC in its oversight role. However, registering as an investment adviser in accordance with the current provisions of the Advisers Act should be a management undertaking for most Private Fund Advisers.