As described in the Lowenstein Sandler Client Alert available here, on June 22, 2011, the Securities and Exchange Commission (the “SEC”) released three significant final rule releases (collectively, the “Final Rules”) relating to its rulemaking initiative under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”), which was signed into law by President Obama in July of last year. The Final Rules were issued after a period of public comment relating to proposed rules released by the SEC on November 19, 2010. (The Lowenstein Sandler client alert analyzing those proposed rules may be found here.)
Among other items, the Final Rules:
- provide that investment advisers previously relying on the Section 203(b)(3) “private adviser” exemption to registration (which Dodd-Frank eliminated effective July 21, 2011) will have until March 30, 2012, to register with the SEC (absent an available exemption from registration);
- provide for the implementation of an exemption from registration for investment advisers that solely advise private funds and manage less than $150 million in assets (with respect to non-U.S. investment advisers, in the United States);
- provide for the implementation of an exemption from registration for foreign private advisers; provide for the implementation of an exemption from registration for investment advisers that solely advise venture capital funds;
- clarify the requirements for registration with the SEC for certain “mid-sized investment advisers” with assets under management between $25 million and $100 million;
- amend Form ADV to establish certain reporting requirements for certain investment advisers that are exempt from registration with the SEC;
- expand the information required to be provided on Form ADV by registered investment advisers that advise private funds; and
- amend the political contributions (i.e., pay-to-play) rule that was adopted in 2010.
Big Changes to Investment Adviser Registration Are Now Final
The Final Rules provide that investment advisers previously relying on the so-called “private adviser exemption” set forth in Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which was eliminated by the Dodd-Frank Act as of July 21, 2011, may delay registering as investment advisers until March 30, 2012. This postponement of the registration deadline was widely anticipated by the industry following previous hints by the SEC of such an extension. Investment advisers relying on this extension should note that the Final Rules specify that, because initial applications for registration can take up to 45 days to become effective, registration applications should be filed by February 14, 2012.
One possible unintended result of this delayed federal registration date is that it could, in theory, result in many investment advisers being forced to register on the state level (since the registration laws or rules of certain states reference the now-ineffective federal private adviser exemption) or face possible breach of contract claims with respect to their advisory contracts if the adviser represents it is duly registered in all jurisdictions where it is required to be so registered. Some states (e.g., California) have, however, responded with emergency amendments to their investment adviser statutes to prevent this unintended consequence.
As previously discussed, the Dodd-Frank Act provides for certain new exemptions from registration under the Advisers Act, including (i) an exemption for advisers solely to venture capital funds (the “venture capital fund exemption”); (ii) an exemption for advisers solely to private funds with less than $150 million in assets under management in the United States, without regard to the number or type of private funds (the “private fund adviser exemption”); and (iii) an exemption for certain non-U.S. advisers with no place of business in the United States and minimal assets under management attributable to U.S. clients and investors (the “foreign private adviser exemption”).
Asset Threshold for Investment Adviser Registration Has Been Raised
As discussed in previous Lowenstein Sandler Client Alerts, the Dodd-Frank Act contains a provision raising the assets-under-management threshold for investment advisers to register with the SEC from $25 million to $100 million. These thresholds are intended to delineate regulatory resources between the states and the SEC. Under the Final Rules, mid-sized advisers (advisers with between $25 million and $100 million of assets under management) will generally be prohibited from registering with the SEC if (i) such investment advisers are required to be registered with the state in which they maintain their principal office and place of business, and (ii) if registered with such state, such investment advisers would be subject to examination by such state. Similarly, such mid-sized advisers will not be prohibited from registering with the SEC (a) if such investment advisers are not required to be registered as an investment adviser with the securities commissioner (or any agency or office performing similar functions) of the state in which they maintain their principal office and place of business; (b) if, being registered, such investment advisers would not be subject to examination as an investment adviser by that securities commissioner; or (c) if such investment advisers are required to register in 15 or more states. In addition, the increased asset threshold does not apply to an investment adviser to a registered investment company or a business development company. The Final Rules provide some clarity on these items by noting which states do not subject registered investment advisers to examination (i.e., Minnesota, New York and Wyoming). Any mid-sized investment adviser with a principal office and place of business in such states will be required to register (or maintain its registration) with the SEC, absent an available exemption from registration.
In furtherance of the authority granted to the SEC by Congress, the Final Rules have raised the $100 million threshold to $110 million, although mid-sized advisers may register with the SEC if they have assets under management of at least $100 million. Once registered with the SEC, an investment adviser need not withdraw its registration until it has less than $90 million of assets under management. The Final Rules require mid-sized investment advisers registering with the SEC to affirm on an annual basis that they are not required to be registered as an investment adviser with the state where they maintain their principal office and place of business (or, if they were to be so registered, that they would not be subject to examination by that securities commissioner).
Advisers to Private Funds With Less Than $150 Million in Assets Under Management Are Now Exempt Reporting Advisers
The Dodd-Frank Act provides that any investment adviser that acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million shall be exempt from the registration requirements under the Advisers Act. As discussed in more detail below, however, the Final Rules require such advisers (and advisers relying on the venture capital exemption discussed in this Client Alert) to maintain records and provide to the SEC any reports that the SEC determines are “necessary or appropriate in the public interest or for the protection of investors.” Also, as discussed in more detail below, the Final Rules require such advisers to fulfill certain informational filing obligations by filing Form ADV Part 1. The Final Rules note that investment advisers relying on this exemption from registration may not combine the exemption with other exemptions (e.g., the venture capital exemption).
In order to rely on this exemption, U.S. investment advisers (i.e., investment advisers with their principal office and place of business in the United States) must include the value of assets for each private fund they manage, regardless of where such private funds are organized. Non-U.S. advisers (i.e., investment advisers with their principal office and place of business outside the United States) may avail themselves of this exemption as long as (i) such investment advisers have no clients that are U.S. persons (other than one or more private funds); and (ii) all assets managed by such investment advisers from a place of business in the United States are attributable solely to private funds, and the total value of such assets is less than $150 million. The Final Rules note that the SEC will not view providing research or conducting due diligence to be “continuous and regular supervisory or management services” for the purposes of determining whether a non-U.S. adviser is managing assets in the United States. The distinctive treatment of U.S. and non-U.S. investment advisers for the purposes of this exemption would allow a non-U.S. adviser to advise non-U.S. clients that are not private funds (i.e., non-U.S. managed account clients), as long as such investment adviser’s U.S.-person clients meet the requirements of this exemption. The Final Rules note that the exemption reflects the SEC’s long-held view that non-U.S. activities of non-U.S. advisers are less likely to implicate U.S. regulatory interests.
Unlike the November 2010 proposed rules, the Final Rules allow investment advisers to determine the amount of private fund assets on an annual basis (rather than quarterly), based on the fair value of such assets. This assessment will include uncalled capital commitments. Investment advisers exceeding the $150 million threshold will have a transition period of 90 days after filing their annual Form ADV updating amendment in order to register with the SEC, provided that such investment advisers have complied with all SEC reporting requirements applicable to “exempt reporting advisers” (discussed in this Client Alert). Investment advisers that have failed to comply with such reporting requirements will have no such grace period to register. However, investment advisers relying on this exemption that subsequently consider accepting non-private fund clients will not have such a grace period, and must register prior to accepting such clients.
The Final Rules also provide some clarity with respect to determining what constitutes a “private fund” for the purposes of the exemption. Specifically, the Final Rules note that single-investor funds will generally not be considered “private funds” for the purposes of the exemption (except in certain limited circumstances, such as where a fund seeks to raise capital from multiple investors but has only a single, initial investor for a period of time and where a fund only has one investor due to redemptions by other investors).
Advisers to Venture Capital Funds Are Now Exempt Reporting Advisers
As we have noted in previous Client Alerts, the Dodd-Frank Act exempts from registration investment advisers that solely advise venture capital funds, and also directs the SEC to define the term “venture capital fund” for purposes of this exemption.
In response to this direction, the Final Rules define a venture capital fund as a private fund (or a non-U.S. fund that would be a private fund if sold in the U.S.) that:
- holds no more than 20% of the fund’s capital commitments in non-qualifying investments (other than short-term holdings) (“qualifying investments” generally consist of equity securities of “qualifying portfolio companies” that are directly acquired by the fund);
- is generally not leveraged;
- does not, except in certain limited circumstances, offer its investors redemption rights or other similar liquidity rights;
- represents itself as a venture capital fund to investors; and
- is not registered under the Investment Company Act.
Like the November 2010 rule proposal, the Final Rules also establish a grandfathering provision for certain existing funds that would not meet all these requirements but have held themselves out historically as venture capital funds. Unlike the November 2010 proposal, the Final Rules do not require any level of managerial assistance or control of portfolio companies by venture capital funds in order to satisfy this exemption. Certain of the requirements under this exemption are discussed in more detail below. It should also be noted that, unlike the less than $150 million exemption discussed above, the venture capital fund exemption would apply equally to U.S. advisers and non-U.S. advisers (i.e., non-U.S. advisers relying on this exemption may not advise any non-U.S. client other than a venture capital fund, as described in the Final Rules).
As discussed in more detail below, the Final Rules attempt to distinguish venture capital funds from other types of private funds, such as hedge funds and private equity funds, while simultaneously providing investment advisers to venture capital funds with flexibility to effectively manage their businesses.
Qualifying Portfolio Company
As provided above, a venture capital fund is, among other things, a private fund that holds no more than 20% of its capital commitments in “non-qualifying investments” (other than short-term holdings), with “qualifying investments” generally consisting of equity securities of “qualifying portfolio companies.” The Final Rules define a “qualifying portfolio company” as any company that: “(i) is not publicly traded; (ii) does not borrow or issue debt obligations in connection with the venture capital fund’s investment in the company and distribute to the fund the proceeds of such borrowing or issuance in exchange for the fund’s investment; and (iii) is not itself a fund (i.e., is an operating company).”
In an attempt to simultaneously allow venture capital funds to effect investments that benefit their investors while balancing congressional concerns expressed about the nature of venture capital fund investments during the Dodd-Frank Act debates, the Final Rules allow a venture capital fund to invest up to 20% of its capital in a “non-qualifying basket” of investments. Non-qualifying investments include, without limitation, publicly traded securities and non-equity securities such as nonconvertible debt instruments. The Final Rules note that an investment adviser has the discretion to choose how to allocate investment opportunities among such investments, as long as the 20% cap is not exceeded.
Represents Itself as a Venture Capital Fund
As mentioned above, the Final Rules provide that, under the venture capital fund exemption, a qualifying fund must represent itself as pursuing a venture capital strategy. The Final Rules note that this criterion remains an important distinction between funds that are eligible to rely on the venture capital fund definition and funds that are not, and that an investor’s understanding of a fund’s investment strategy should be consistent with an investment adviser’s reliance on an available exemption. The Final Rules do, however, provide “that it is not necessary (nor indeed sufficient) for a qualifying fund to name itself as a ‘venture capital fund’ in order for its adviser to rely on the venture capital exemption.”
In order to meet the requirements for the grandfathering provision, the Final Rules specify that proposed venture capital funds must (i) have represented to investors and potential investors that they were venture capital funds at the time of offering their securities; (ii) have sold securities to one or more investors prior to December 31, 2010; and (iii) not sell securities to, or accept additional capital commitments from, any person after July 21, 2011. This grandfathering provision would include any proposed venture capital fund that has accepted capital commitments by the specified dates, even if the fund has not called the commitments.
Investment Advisers Exempt From Registration by Virtue of the Venture Capital and Less Than $150 Million Exemptions Must Still Keep Records and File Reports
The Dodd-Frank Act authorizes the SEC to require certain investment advisers that are exempt from registration (i.e., investment advisers that rely on the venture capital fund and private fund adviser exemptions discussed above) to maintain certain records and submit certain reports to the SEC. Therefore, the Final Rules require these “exempt reporting advisers” to complete and file, between January 1, 2012, and March 30, 2012, certain items in Part 1A of Form ADV, thereby providing, among other things, information relating to (i) basic identification of the investment adviser’s owners and affiliates; (ii) the private funds managed by the investment adviser and its business activities presenting potential conflicts of interest (much of which is contained in Item 7.B. and Section 7.B.(1), Schedule D of Form ADV, Part 1A, which are discussed above); and (iii) disciplinary action taken against the investment adviser or certain of its employees. These informational reports will be publicly available on the SEC’s website. After March 30, 2012, exempt reporting advisers must file the information required by Form ADV within 60 days of relying on the applicable exemption from registration. Exempt reporting advisers will be required to update the information disclosed on Form ADV (i) at least annually, within 90 days of the end of the adviser’s fiscal year; and (ii) more frequently, if required by the instructions to Form ADV (e.g., upon any changes to the adviser’s form of organization or disciplinary information).
While exempt reporting advisers are potentially subject to the SEC’s examination authority, the SEC has stated that it does not intend to subject exempt reporting advisers to routine examinations. The SEC has stated, however, that it would exercise this authority if there are indications that it should do so. As with the November 2010 rule proposal, certain SEC commissioners expressed concern that these reporting requirements remove any meaningful distinction between registered advisers and exempt advisers.
Private Advisers Are Now Exempt From Registration
The Dodd-Frank Act amended Section 203(b)(3) of the Advisers Act by creating an exemption from registration for certain “foreign private advisers.” A foreign private adviser is defined in the Dodd-Frank Act as any investment adviser that (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients in the United States and investors in the United States in private funds advised by the adviser; (iii) has aggregate assets under management, attributable to clients in the United States and investors in the United States in private funds advised by the adviser, of less than $25 million; (iv) does not hold itself out to the public in the United States as an investment adviser; and (v) does not act as an investment adviser to either a registered investment company or a company that has elected to be treated as a business development company under the Investment Company Act of 1940, as amended (the “Investment Company Act”).
Place of Business
The Final Rules define “place of business” as any office where an investment adviser regularly “provides advisory services, solicits, meets with, or otherwise communicates with clients, and any location held out to the public as a place where the investment adviser conducts any such activities.” This definition was adopted as proposed in the November 2010 rule release.
Under the Final Rules, a single client, for the purposes of this exemption, would include (i) certain family members; (ii) an entity to which the investment adviser provides investment advice based solely on such entity’s investment objectives; and (iii) two or more entities that have identical shareholders, partners, limited partners, members or beneficiaries. The Final Rules also include certain provisions that avoid double counting. Specifically, the Final Rules provide that a non-U.S. investment adviser will not be required to count (A) a private fund as a client if such investment adviser counts any investor in that private fund for the purposes of determining such investment adviser’s ability to rely on this exemption, and (B) a person as an investor if the investment adviser counts such person as a client of the investment adviser.
The Final Rules define an “investor” to include any person who would be included in determining the number of beneficial owners in accordance with Section 3(c)(1) of the Investment Company Act, or whether the outstanding securities of a private fund are owned exclusively by qualified purchasers under Section 3(c)(7) of such Act. The Final Rules also generally treat beneficial owners of short-term paper issued by the private fund as “investors” for the purposes of this exemption. A non-U.S. investment adviser also may treat as a single investor any person who is an investor in two or more private funds advised by such investment adviser. Unlike the November 2010 proposal, the Final Rules do not treat “knowledgeable employees” as an investor for the purposes of this exemption.
“In the United States”
The Final Rules define “in the United States” to generally be consistent with Regulation S under the Securities Act of 1933, as amended. Specifically, the Final Rules define “in the United States” to mean “(i) with respect to any place of business located in the ‘United States,’ as that term is defined in Regulation S; (ii) with respect to any client or private fund investor in the United States, any person that is a ‘U.S. person’ as defined in Regulation S (which includes partnerships or corporations organized or incorporated under the laws of the United States and any trust of which any trustee is a U.S. person), except that any discretionary account or similar account that is held for the benefit of a person ‘in the United States’ by a non-U.S. dealer or other professional fiduciary is deemed ‘in the United States’ if the dealer or professional fiduciary is a related person of the investment adviser relying on the exemption; and (iii) with respect to the public in the ‘United States,’ as that term is defined in Regulation S.” The Final Rules do, however, specify that a person who is “in the United States” may be treated as not being “in the United States” if the person was not “in the United States” at the time of becoming a client or, in the case of an investor in a private fund, each time the investor acquires securities issued by the private fund.
The Method for Calculating Assets Under Management Is Now Uniform and Broader
The Final Rules establish a revised method for calculating advisory assets under management for the registration, exemption and reporting purposes discussed in this Client Alert. Under the Final Rules, investment advisers must include in the assets under management calculation on a gross basis (i.e., without deduction of any outstanding indebtedness or other accrued but unpaid liabilities) family or proprietary assets, assets managed without receiving compensation, assets of foreign clients and uncalled capital commitments. This method, which the Final Rules term “regulatory assets under management,” is a departure from, and is more expansive than, the current method of calculating AUM for regulatory purposes. With respect to private funds, investment advisers must include in the assets under management calculation the fair value of any private fund over which they exercise continuous and regular supervisory or management services, regardless of the nature of the assets held by the fund. An investment adviser acting as a sub-adviser may include only that portion of such private fund’s assets over which it provides advisory services in the regulatory assets under management calculation. An investment adviser’s regulatory assets under management must be valued at “fair value,” but an investment adviser need not utilize the services of a third-party calculation agent or pricing service in meeting this “fair value” requirement.
Registered Investment Advisers Now Have Expanded Recordkeeping and Reporting Obligations
As we have mentioned in previous Client Alerts, the Dodd-Frank Act subjects registered investment advisers to private funds to certain expanded recordkeeping and regulatory reporting requirements, which are implemented by the Final Rules via revisions to Form ADV. Under these expanded requirements, which are primarily contained in Item 7.B. and Section 7.B.(1) of Schedule D of Form ADV, Part 1A, registered investment advisers will be required to report to the SEC, among other items, information relating to such investment advisers’ managed funds (e.g., the size and organizational, operational and investment characteristics of each fund) and information relating to a fund’s auditors, prime brokers, custodians, administrators and marketers. Although these revisions to Form ADV will require investment advisers to report certain information regarding fund investors (e.g., minimum investment requirements, the approximate number of beneficial owners, and the approximate percentage of the fund owned by the investment adviser and its related persons), the Final Rules, unlike the November 2010 proposal, will not require an adviser to report (i) a fund’s net assets, (ii) fund assets and liabilities by class and categorization, or (iii) the percentage of each fund owned by particular types of beneficial owners. The Final Rules state that these reporting requirements (which as discussed below, also apply to exempt reporting advisers) will provide important census-type data for the SEC to use in identifying risks that private funds may pose to investors.
Family Office Exclusion
As discussed in previous Client Alerts, the Dodd-Frank Act provided an exclusion from the definition of “investment adviser” for advisers to a “family office,” which is implemented by the Final Rules. Specifically, the Final Rules provide three principal conditions for the exclusion: the entity must (i) provide advice only to family clients (as defined by the rule), (ii) be wholly owned by family clients and controlled by family members and/or family entities, and (iii) not hold itself out to the public as an investment adviser. The Final Rules define “family clients” as family members (lineal descendants spanning 10 generations, including spouses), key employees, family client trusts, estates, charitable organizations and nonprofit organizations funded exclusively by the family. The Final Rules permit a family, in order to meet the requirements of the exclusion, to choose a common ancestor (who may be deceased) and define “family members” by reference to the degree of kinship to such designated ancestor. The Final Rules will also permit a family to change the designated ancestor over time in order to serve a greater number of collateral family members. The exclusion does not extend to family offices serving multiple families, and such family offices would be required to re-structure, avail themselves of an available exemption from registration or seek exemptive relief from the SEC.
Amendments to the Political Contributions Rules
The Final Rules set forth two proposed amendments to the political contributions rules (i.e., “pay to play” rules) that were approved by the SEC in June 2010. Specifically, the Final Rules (i) clarify that such rules would apply to both investment advisers that are exempt from registration but subject to SEC reporting requirements and “foreign private advisers” and (ii) include “municipal advisors” (as defined by the Dodd-Frank Act and the SEC’s rules thereunder) as a category of persons or entities that investment advisers may pay to solicit government entities.
The Final Rules represent one portion of the substantial changes that are occurring in the investment management industry. With the revisions to Section 203(b)(3) of the Advisers Act, the private adviser exemption (previously relied on by many investment advisers to private funds) is now gone, and many investment advisers now face significant changes in the regulatory landscape governing their businesses. In order to effectively manage these changes to the regulatory landscape, managers should make determinations as to whether they should restructure their operations in order to meet new exemption requirements, whether they must or may register with one or more states or the SEC, and whether they must or may remain registered with the SEC. Those managers obtaining SEC registration for the first time will face new regulatory requirements such as new rules relating to recordkeeping, personal trading, performance fees, custody and the requirement to appoint a Chief Compliance Officer. Even managers who are already registered with the SEC will face new reporting requirements, including a thoroughly revised Form ADV.
Investment advisers should begin preparing now for the transition periods implemented by the Final Rules. For instance, investment advisers that will be required to register with the SEC must file their Form ADV by February 14, 2012, and be prepared to meet the requirements of the Advisers Act when their Form ADV is declared effective. Investment advisers that are registered with the SEC as of January 1, 2012, must file an amendment to their Form ADV by March 30, 2012, showing their ability to remain registered. Advisers that are no longer eligible to remain registered with the SEC must deregister by filing Form ADV-W no later than June 28, 2012. Exempt reporting advisers must file Form ADV between January 1, 2012, and March 30, 2012.