On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Act), a broad overhaul of the nation’s financial regulatory system. The following is a detailed summary and analysis of certain provisions of the Act that are likely to have a significant impact on Regulation D private offerings, non-accelerated filers, registered representatives and investment advisers, and private fund advisers, including:

  • the new “accredited investor” standard;
  • disqualification of “bad actors” from Regulation D offerings;
  • the Sarbanes-Oxley 404(b) exemption;
  • fiduciary standards study for registered representatives and investment advisers; and
  • registration and reporting requirements for advisers of private funds and other investment managers.

I. Regulation D Private Offerings

A. Modification to the Accredited Investor Standard

Since 1982, issuers have been able to rely on the safe harbor provisions of Regulation D under the Securities Act of 1933, as amended (the Securities Act) to issue securities in private placements without registering those securities with the Securities and Exchange Commission (SEC). Under Rule 506 of Regulation D, an issuer may sell an unlimited amount of unregistered securities to unlimited numbers of “accredited investors” and up to 35 non-accredited investors. The reasoning was that those investors who have sufficient financial sophistication and the ability to properly evaluate the risks and rewards of making the investment do not need the same protections of the securities laws.

Under the rules prior to the Act, an individual qualifies as an accredited investor if that individual meets either of two tests: (i) the individual’s net worth, or joint net worth when combined with his or her spouse (including the value of his or her primary residence), exceeds $1 million at the time the securities are purchased (Net Worth Test), or (ii) the individual had income exceeding $200,000, or joint income with his or her spouse exceeding $300,000, in each of the two most recent years, and that individual or couple expects to meet those income thresholds in the current year (Income Test). The SEC, among others, expressed concern that the existing accredited investor standard for individuals as originally enacted in 1982 is outdated and has not been adjusted to account for inflation and increases in property value. Section 413 of the Act modifies the accredited investor Net Worth Test standard for individuals, effective immediately upon enactment to $1 million, excluding the value of the investor’s primary residence. Although the dollar threshold for the Net Worth Test is not being increased, by excluding the value of an investor’s primary residence, the Act has effectively tightened the eligibility standards for individuals to meet the test for accredited investors. In response to the Act, on July 23, 2010, the SEC published new staff guidance, noting that when determining net worth for accredited investor purposes, the value of an individual’s primary residence, as well as the related amount of any mortgage or other indebtedness secured by such residence, must be excluded. In addition, the SEC indicated that, pending future SEC rulemaking as a result of the Act, any indebtedness secured by the residence in excess of the home’s value should be considered a liability and deducted from the investor’s net worth.  

The Act further authorizes the SEC, one year after enactment, to review and modify the accredited investor definition applicable to individuals “as appropriate for the protection of investors, in the public interest, and in light of the economy.” Moreover, the Act requires the SEC to conduct a review of the entirety of the definition of accredited investors every four years. Therefore, although the Act does not directly modify the Income Test or increase the dollar threshold for the Net Worth Test to adjust for almost three decades of inflation, the SEC may do so as part of its subsequent review process. In addition, the SEC’s directive to look at the definition “in light of the economy” creates some uncertainty as to whether that would potentially increase or decrease the $1 million threshold.  

Practice Notes: The Act does not grandfather, for purposes of the Net Worth Test, current and ongoing offerings. Thus, private offering issuers should immediately update their subscription documents for ongoing and future private offerings to reflect the exclusion of an individual’s primary residence for purposes of determining accredited investor status. Issuers should also require existing investors who are individuals to represent that they meet this updated net worth standard before accepting additional subscriptions. No action is required with respect to existing investors who are not making additional investments. This could result in disruptions to ongoing offerings and potentially eliminate investors who previously were accredited investors from current offerings.

B. Disqualifying Felons and Other “Bad Actors” from Regulation D Offerings

Section 926 of the Act also requires the SEC, within one year of its enactment, to issue rules that are substantially similar to Rule 262 of the Securities Act and which disqualify an offering or sale of securities made in reliance upon Regulation D where the person offering the securities:

  • has been convicted of any felony or misdemeanor in connection with purchase or sale of any security or in connection with any false filing with the SEC; or
  • is subject to a final order of a state securities commission, a state authority that supervises or examines banks, savings associations, or credit unions, a state insurance commission, a federal banking agency, or the National Credit Union Administration, that (i) bars the person from (a) association with a regulated entity; (b) engaging in the business of securities, insurance, or banking; or (c) engaging in savings association or credit union activities; or (ii) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the previous 10-year period.

II. Sarbanes-Oxley Section 404(b) Exemption

Section 404(a) of the Sarbanes-Oxley Act of 2002 (SOX) requires annual reports on Form 10-K to contain a report from management regarding the effectiveness of the issuer’s internal control over financial reporting. Section 404(b) of SOX requires that the issuer’s regular auditor attest to and report on management’s assessment. The SEC initially allowed non-accelerated filers, which are reporting companies with a public float under $75 million and that fail to meet other criteria established by the SEC for an “accelerated filer” or “large accelerated filer” based on reporting characteristics, to postpone their compliance with Section 404(a) until their annual report was filed for a fiscal year ending on or after December 15, 2007. The SEC’s most recent deferral of compliance with Section 404(b) for non-accelerated filers was extended to those non-accelerated filers who would be required to file annual reports with fiscal years ending on or after June 15, 2010.

The Act provides that small issuers that are neither a large accelerated filer nor an accelerated filer are permanently exempt from complying with the auditor attestation provisions in Section 404(b) of SOX, effective upon enactment of the Act. Although non-accelerated filers remain subject to Section 404(a) of SOX, this exemption will reduce costs associated with being a public reporting company. A 2009 survey by the SEC of public companies that historically complied with SOX found that for issuers whose market capitalization was under $75,000,000, the average cost of compliance with Section 404(b) of SOX was approximately $440,000. The Act further directs the SEC to conduct a study to determine how to reduce the burden of complying with Section 404(b) for companies whose market capitalization is between $75,000,000 and $250,000,000.

III. Fiduciary Standards Study

Within six months of enactment, Section 913 of the Act directs the SEC to conduct a study to evaluate the effectiveness of, and gaps or overlaps that should be addressed by, rule or statute in the existing legal and regulatory standards of care for brokers, dealers, investments advisers and their associated persons when providing personalized investment advice and recommendations about securities to their respective “retail customers.” A “retail customer” is defined as a natural person, or his or her legal representative, who (i) receives personalized investment advice about securities from a broker, dealer, or investment adviser, and (ii) uses such advice primarily for personal, family or household purposes. The SEC must submit a report to the Senate Banking, Housing and Urban Affairs Committee and the House Financial Services Committee containing its findings and recommendations within six months of the Act’s enactment. Upon the conclusion of this study, Section 913 gives the SEC the discretion to establish a uniform fiduciary duty for those individuals who provide personalized investment advice to retail clients or other customers.  

In completing its study, the Act directs the SEC to consider, among other things, the following:  

  • the effectiveness of existing legal and regulatory standards of care for brokers, dealers, investments advisers and their associated persons;  
  • any gaps, shortcomings or overlaps in legal or regulatory standards of care relating to such persons;  
  • retail customer understanding of differences in standards of care applicable to such persons;  
  • any retail customer confusion related to differing standards of care and the quality of advice that they receive;  
  • the regulatory, examination and enforcement resources devoted to, and the activities of, the SEC, the states and a national securities association to enforce the standards of care applicable to broker-dealers, investments advisers and their respective associated persons, including the frequency, length of time and effectiveness of such examinations in determining compliance with regulations;  
  • the existing legal or regulatory standards of state securities regulators and other regulators intended to protect retail customers;  
  • the potential impact on retail customers and their access to products and services of imposing on brokers, dealers and associated persons the standards of care and other requirements applied under the Investment Advisers Act of 1940, as amended (the Advisers Act);  
  • the potential benefits and harm to retail customers, number of and additional costs to entities and individuals that would become subject to the Advisers Act, and the potential impact onto the SEC and the states, if the broker exception is eliminated from the definition of “investment adviser” in the Advisers Act; and  
  • the potential impact upon retail customers that may result from potential changes in the regulatory requirements or standards of care affecting brokers, dealers, investments advisers and their associated persons, including any potential impact on protection from fraud, and access to and the availability of personalized investment advice and recommendations about securities.  

In conducting this study, the SEC will examine difficult questions relating to the “harmonization” of duties owed to clients by broker-dealers and investment advisers. The Act, however, resolves some of these difficult questions for the SEC.  

Practice Notes: Under the rulemaking authority provided in the Act, Congress stated specifically that:  

  • broker-dealers’ receipt of commissions or other standard forms of compensation, in and of themselves, cannot be deemed to violate the applicable standard of care;  
  • broker-dealers will not violate any duty if they sell only proprietary or a limited range of products;

• broker-dealers will not be subject to continuing duties of care or loyalty after providing personalized investment advice to customers; and  

• customers of broker-dealers and investment advisers will be able to consent to material conflicts of interest if they are adequately disclosed.

IV. Regulation of Private Funds and Their Advisers

Article IV of the Act, the “Private Fund Investment Advisers Registration Act of 2010,” substantially amends provisions of the Advisers Act relating to the registration, reporting and recordkeeping obligations applicable to private funds and their advisers. Previously, private equity and hedge fund advisers generally were not required to register with the SEC or comply with related reporting, recordkeeping and other burdens by relying upon the “private investment adviser” exemption available under Section 203(b)(3) of the Advisers Act. The Act eliminates the “private investment advisers” exemption, although private fund advisers may rely on other registration exemptions. The registration, reporting and recordkeeping obligations applicable to private equity and hedge fund advisers will become effective one year after the Act is enacted.

It is important to note that the Act only establishes a framework for heightened regulation of the private funds industry, and Congress has authorized the SEC and other federal regulators to fill gaps in the Act’s provisions and complete this process through further analytical review, rulemaking and interpretation. As with the implementation and rulemaking that took place after enactment of SOX, this administrative process will dictate important aspects of the reform and the exact ways in which the new legislation will affect private funds and their advisers. As a result, it will likely be quite some time until such reforms are broadly implemented and the direct and indirect impact of the Act on the private funds industry is fully understood.

A. Registration of Investment Advisers to Private Funds

Prior to this Act, many private fund advisers, including advisers of hedge funds, private equity funds and venture capital funds, were exempt from registration with the SEC regardless of the amount of their assets under management, in reliance on the “private investment adviser” exemption in the Advisers Act. Section 203(b)(3) of the Advisers Act currently provides a “private investment adviser” exemption for an investment adviser that (i) has had fewer than 15 clients during the preceding 12 months (each fund vehicle is generally treated as a separate client for this purpose), (ii) does not hold itself out generally to the public as an investment adviser and (iii) does not act as an investment adviser to any registered investment company or business development company. Under the Act, however, private equity and hedge fund advisers will be required to register with the SEC if their advisee funds and other client accounts have assets under management of at least $150 million. The Act defines a “private fund” to be any vehicle which would have been required to register under the Investment Company Act of 1940, as amended (the “1940 Act”), but for the exceptions provided by Section 3(c)(1) or Section 3(c)(7) of the 1940 Act. As a result, investment advisers to many private funds that were previously exempt from registration, subject to certain exceptions, will now be required to register with the SEC.

The Act, however, also creates new registration exemptions under the Advisers Act:  

  • Advisers to Venture Capital Funds. Investment advisers that act as advisers solely to one or more venture capital funds are exempt from the registration requirements of the Advisers Act. The Act requires the SEC to issue final rules defining “venture capital fund” and authorizes the SEC to impose recordkeeping and reporting requirements on unregistered venture capital fund advisers.
  • Advisers to Family Offices. Under the Act, investment advisers that act as advisers to “family offices” are excluded from the definition of investment adviser, and therefore are exempt from the registration requirements of the Advisers Act. The Act requires the SEC to issue final rules defining “family offices” in a manner consistent with the existing exemptive orders and in light of the range of organizational, management and employment structures that family offices utilize.
  • Advisers with Limited Assets Under Management. The Act directs the SEC to exempt from registration any adviser that solely advises private funds and has assets under management in the United States of less than $150 million. The SEC is further authorized to impose recordkeeping and reporting requirements on such advisers.
  • Foreign Private Advisers. Foreign private advisers are exempt from registration and recordkeeping and reporting requirements. The Act defines a “foreign private adviser” as any investment adviser that:
    • has no place of business in the United States;  
    • has, in total, fewer than 15 clients and investors in the private funds it advises;  
    • has less than $25 million (or a higher amount as the SEC deems appropriate) of aggregate a ssets under management attributable to clients in the United States and United States investors in private funds it advises; and  
    • neither holds itself out generally to the public in the United States as an investment adviser, n or acts as an adviser to any registered investment company or business development company.  
  • Advisers to Small Business Investment Companies. Under the Act, any investment adviser (other than a business development company) that solely advises small business investment companies licensed under the Small Business Investment Act of 1958 is exempt from the registration requirements of the Advisers Act.  
  • Advisers to Mid-sized Private Funds. The Act requires the SEC to take into account the size, governance and investment strategy of “mid-sized private funds” (which term is not defined in the Act) to determine whether such funds pose systemic risk and to prescribe registration and examination requirements for investment advisers to such private funds that reflect those risks.

The Act, however, also creates new registration exemptions under the Advisers Act:  

  • Advisers to Venture Capital Funds. Investment advisers that act as advisers solely to one or more venture capital funds are exempt from the registration requirements of the Advisers Act. The Act requires the SEC to issue final rules defining “venture capital fund” and authorizes the SEC to impose recordkeeping and reporting requirements on unregistered venture capital fund advisers.  
  • Advisers to Family Offices. Under the Act, investment advisers that act as advisers to “family offices” are excluded from the definition of investment adviser, and therefore are exempt from the registration requirements of the Advisers Act. The Act requires the SEC to issue final rules defining “family offices” in a manner consistent with the existing exemptive orders and in light of the range of organizational, management and employment structures that family offices utilize.  
  • Advisers with Limited Assets Under Management. The Act directs the SEC to exempt from registration any adviser that solely advises private funds and has assets under management in the United States of less than $150 million. The SEC is further authorized to impose recordkeeping and reporting requirements on such advisers.  
  • Foreign Private Advisers. Foreign private advisers are exempt from registration and recordkeeping and reporting requirements. The Act defines a “foreign private adviser” as any investment adviser that:  
    • has no place of business in the United States;  
    • has, in total, fewer than 15 clients and investors in the private funds it advises;  
    • has less than $25 million (or a higher amount as the SEC deems appropriate) of aggregate a ssets under management attributable to clients in the United States and United States investors in private funds it advises; and  
    • neither holds itself out generally to the public in the United States as an investment adviser, n or acts as an adviser to any registered investment company or business development company.  
  • Advisers to Small Business Investment Companies. Under the Act, any investment adviser (other than a business development company) that solely advises small business investment companies licensed under the Small Business Investment Act of 1958 is exempt from the registration requirements of the Advisers Act.  
  • Advisers to Mid-sized Private Funds. The Act requires the SEC to take into account the size, governance and investment strategy of “mid-sized private funds” (which term is not defined in the Act) to determine whether such funds pose systemic risk and to prescribe registration and examination requirements for investment advisers to such private funds that reflect those risks.

As a result, some investment advisers that are initially exempt from registration may later become subject to registration and additional reporting requirements as a result of SEC rulemaking.  

  • State-Registered Advisers. An investment adviser that is required to be registered with the state in which it has its principal office and that has assets under management between $25 million and $100 million, is not required to register with the SEC. However, an investment adviser that meets these requirements must register with the SEC if the investment adviser (a) is an adviser to a registered investment company, (b) is an adviser to a business development company, or (c) would otherwise be required to register with 15 or more states.  

The Act also modified some existing exemptions from registration:  

  • Modification of “Intrastate Adviser” Exemption. The Act modified the intrastate exemption from registration in Section 203(b)(1) of the Advisers Act, which previously applied to any investment adviser whose clients were all residents of the state in which such adviser maintained its principal office and place of business, provided such adviser did not advise with respect to listed securities or securities otherwise traded on any national securities exchange. Under the Act, any such adviser is now subject to registration even if one of its clients is a private fund, and that fund is located in the same state as the adviser.  
  • Modification of Exemption for Advisers Registered as Commodity Trading Advisers. The Advisers Act currently exempts from registration any investment adviser that is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading adviser if its business does not consist primarily of acting as an investment adviser and if it does not act as an investment adviser to any registered investment company or business development company. Section 403 of the Act expands this exemption to any investment adviser that is registered with the CFTC as a commodity trading adviser and advises a private fund; provided, that if the business of such investment adviser should become predominately the provision of securities-related advice, then such investment adviser would be required to register with the SEC.

B. Reporting and Recordkeeping Requirements

Advisers of private funds that will now be required to register with the SEC will be subject to new reporting and recordkeeping requirements in addition to the existing reporting and recordkeeping provisions of the Advisers Act. The Act authorizes the SEC to require registered investment advisers to maintain records (for such periods as the SEC prescribes) and file such reports with the SEC as are deemed necessary or appropriate in the public interest or for purposes of “systemic risk” assessments made by the newly established Financial Stability Oversight Council (the Council). All such records will also be subject to periodic and special examination by the SEC. The records required to be maintained (and made available for SEC inspection and subject to SEC filing requirements to be prescribed) in respect of each private fund advised by an investment adviser will include information on:

  • the amount of assets under management;
  • use of leverage, including off balance sheet leverage;
  • counterparty credit risk exposure;
  • trading and investment positions;
  • valuations policies and practices;
  • types of assets held;
  • side arrangements or side letters whereby certain investors in a fund obtain more favorable rights or entitlements than other investors; and
  • trading practices of the fund.

Such private funds will also be required to maintain, and make available to the SEC, such other information as the SEC, in consultation with the Council, determines is necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk. The Act provides that the “other information” requirements may include the establishment of different reporting requirements for different classes of fund advisers, based upon the type or size of private fund being advised. This broad “other information” category provides the SEC with significant flexibility in determining what information may be required and the specific content and form of the reports to be filed with the SEC. As a result, the precise impact and burden of private fund advisers’ SEC reporting obligations will not be known until such obligations are detailed through SEC rulemaking.  

To the extent that any “proprietary information” of a private fund is contained in reports required to be filed with the SEC, the Act provides for protections from public disclosure under the Freedom of Information Act. The term “proprietary information” is defined to include sensitive, non-public information regarding the investment or trading strategies of the investment adviser, analytical or research methodologies, trading data, computer hardware or software containing intellectual property and any additional information which the SEC deems to be proprietary. The Act requires the SEC to report to Congress annually about how it used data it collected to monitor markets and protect investors and the markets.

The Act also provides that the new registration requirements under the Act for private fund advisers do not eliminate any registration obligations of such advisers, if any, under the Commodity Exchange Act. Further, the SEC and the CFTC are required, in consultation with the Council and no later than one year after enactment, to jointly establish rules governing the form and content of reports to be filed with the SEC and with the CFTC by investment advisers registered both under the Advisers Act and the Commodity Exchange Act.

C. Implementation of Registration, Reporting and Recordkeeping Provisions

Title IV of the Act, which contains the private fund adviser registration, reporting and recordkeeping provisions, takes effect one year after the date of enactment (i.e., July 2011). During this period, the SEC is expected to adopt the rules and regulations relating to registration and reporting, which will dictate the true impact of these reforms on the private funds industry.

During this one year phase-in period, advisers may voluntarily register with the SEC. As part of this rulemaking process, the SEC is expected to provide guidance regarding the transition from the existing registration regime to the new registration regime.  

V. Conclusion

While the passage of the Act represents a significant development in the regulation of the private funds industry and noteworthy amendments to Regulation D private offerings, over the next several years, a significant number of studies, rules and regulations required by the Act will be prepared and implemented. As this process unfolds, the impact of the new legislation on these industries will become clearer. We will continue to monitor and report on the progress of these regulatory developments.