Investment advisers are regulated in the United States under the U.S. Investment Advisers Act of 1940 (the Advisers Act)1. Effective July 21, 2011, the private adviser exemption that many investment advisers historically relied on to avoid registering with the U.S. Securities and Exchange Commission (the SEC) was eliminated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), which replaced it with three new and very limited exemptions. As a consequence, non-U.S. advisers2 that have U.S. investors in their funds, manage fund vehicles established in the United States, or have a physical presence in the U.S. are potentially subject to registration in the U.S. Indeed, non-U.S. investment advisers who do not qualify for one of the new Dodd-Frank Act exemptions are obligated to register with the SEC and are subject to the same registration requirements, regulatory oversight and other requirements that apply to other SEC-registered investment advisers.
This client alert describes the current rules under the Advisers Act as applicable to non-U.S. investment advisers. This alert gives a general overview as at March 31, 2014 and cannot substitute for bespoken legal advice.
What is the pre-Dodd Frank Act extraterritorial reach of the Advisers Act?
Under a literal reading of the registration requirement contained under Section 203 of the Advisers Act, even foreign investment advisers serving their foreign clients would have to register as investment advisers if they make use of any U.S. jurisdictional means (i.e., the U.S. mail or any means or instrumentality of interstate commerce) in connection with their business as an investment adviser.
However, pursuant to the issuance of certain no-action letters,3 the SEC Staff has interpreted the Advisers Act so as to regulate the activity of non-U.S. advisers only where advisory conduct occurs in the U.S., even if the conduct has no effect on U.S. persons or markets, or where the activity outside the U.S. produces substantial and foreseeable effects in the U.S.4
Under this "conduct and effects" approach, the Advisers Act does not govern the relationship between a non-U.S. adviser and its clients that reside outside the U.S. The SEC Staff has also generally taken the position that registration is not required where a non-U.S. adviser uses a U.S. jurisdictional means solely to obtain research or to place orders for securities with U.S. registered brokers but does not use a U.S. jurisdictional means to solicit clients or give investment advice.
Many questioned whether the amendments to the Advisers Act contained in the Dodd-Frank Act would impact the SEC's views with regard to the applicability of the "conduct and effects" approach. While the SEC stated in the Exemptions Release5 that it was not intending to withdraw any prior statement or views under the Unibanco No-Action Letters, it did not specifically affirm positions taken under these letters, despite acknowledging the request to do so by a number of commentators. Moreover, the SEC noted that "the [Unibanco No-Action Letters] were developed by the staff in the context of the private adviser exemption, which Congress repealed. Nothing in the rules we are today adopting in this [Exemptions] Release is intended to withdraw any prior statements of the [SEC] or the views of the staff as expressed in the [Unibanco No-Action Letters]. We expect that the staff will provide guidance, as appropriate, based on the facts that may be presented to the staff regarding the application of the [Unibanco No-Action Letters] in the context of the new foreign private adviser exemption and the private fund adviser exemption."6
Given these statements made by the SEC and the nature of the Foreign Private Adviser Exemption and Private Fund Adviser Exemption, which by their terms take a territorial approach that focuses on where assets are being managed, advisers should be cautious in relying on the Unibanco No-Action Letters absent further guidance either generally or in respect of specific situations.
Who is an investment adviser under the Adviser Act?
An "investment adviser" is defined as any person or firm that: (i) for compensation; (ii) is engaged in the business of; (iii) advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities (advice about securities).7
The SEC broadly interprets the concept of being engaged in the business of advising. An adviser giving advice on a basis that constitutes a business activity and providing the advice with some regularity is engaged in the business of advising. This does not have to be the sole or even the primary activity of the person. The frequency of the activity is viewed as a factor but is not determinative. Other factors should be considered such as:
- whether the person holds himself out as an investment adviser;
- whether the person receives compensation that represents a clearly definable charge for providing investment advice; and
- the specificity of the investment advice provided.
A person providing advice about specific securities may be deemed to be "engaged in the business of advising" unless specific advice is rendered only on a rare or isolated occasion.
The SEC Staff has also provided guidance about what adviceabout securities entails. Any person providing advice to others about specific securities, such as stocks, bonds, mutual funds, limited partnerships, and commodity pools, for a fee, would fall within the investment adviser definition. However, the SEC also tackled the situation where ancillary advice is provided, or advice that is only indirectly about securities. The SEC Staff has laid out several examples it considers being advice about securities, such as:
- advice about market trends;
- advice about the selection and retention of other advisers;
- advice about the advantages of investing in securities versus other types of investments (e.g., coins or real estate);
- providing a selective list of securities even if no advice is provided as to any one security; and
- asset allocation advice.
What are the post-Dodd Frank Act exemptions available to non-U.S. advisers?
As a result of changes established by the Dodd-Frank Act, the Advisers Act has been amended to provide, three primary exemptions from SEC registration available to non-U.S. advisers:
- the Foreign Private Adviser Exemption;
- the Private Fund Adviser Exemption; and
- the Venture Capital Fund Exemption.
Foreign Private Adviser Exemption
This exemption is intended to replace the private adviser exemption, and is available to an adviser that (i) has no place of business in the U.S.; (ii) has, in total, fewer than 15 clients in the U.S. and investors in the U.S. in private funds advised by the adviser; (iii) has aggregate assets under management attributable to these clients and investors of less than $25 million; and (iv) does not hold itself out generally to the public in the U.S. as an investment adviser. These conditions are cumulative and must all be satisfied to benefit from the exemption.
The SEC Staff defines or explains the following terms that are central to the definition of "foreign private adviser":
- Place of Business. In addition to including an office at which it provides investment advisory services, solicits, meets with, or otherwise communicates with clients, a "place of business" also includes any other location that an adviser holds out to the general public as a place where it provides these services. Offices from which an adviser conducts solely administrative and back office activities will generally not fall under this definition, assuming these activities are not intrinsic to providing investment advisory services and the adviser does not communicate with clients from such location. However, temporary offices such as a hotel or even an auditorium may be included depending on the activities conducted there. The SEC explained that whether a temporary office or location is a place of business "will turn on whether the adviser representative has let it generally be known that he or she will conduct advisory business at the location, rather than on the frequency with which the adviser representative conducts advisory business there." The SEC also stated that any office from which an adviser regularly communicates with its clients, whether U.S. or non-U.S., would be a place of business. In addition, an office or other location where an adviser regularly conducts research would be a place of business because research is intrinsic to the provision of investment advisory services.8
- The Advisers Act defines a private fund as an issuer of securities that would be an investment company "but for" the following exceptions: (i) a fund that does not publicly offer its securities and has 100 or fewer beneficial owners of its outstanding securities, AND (ii) a fund that does not publicly offer its securities and limits its owners to qualified purchasers.9 A private fund includes a private fund that invests in other private funds. A fund organized outside the U.S. that does not use U.S. jurisdictional means to conduct an offering (and, in particular, does not offer interests to U.S. persons) generally would not be a "private fund" for this purpose, under the SEC’s prior interpretation of the Investment Company Act of 1940.
- In the U.S.10 A place of business is treated as being "in the U.S." if it is treated as located in the United States as defined in Regulation S11 promulgated under the U.S. Securities Act of 1933, as amended12 (Regulation S). An investor or client generally is treated as being "in the U.S." if that investor or client is a "U.S. person" for purposes of Regulation S, except with respect to certain discretionary or similar accounts that are held for the benefit of U.S. persons by certain non-U.S. dealers or other non-U.S. professional fiduciaries.13
However, if a person was not actually in the U.S. at the time the person became an investor or client (including each time that an investor in a private fund acquires securities in such fund), that person may be treated for purposes of this rule as not being in the U.S. Under this exception, if subscriptions for private fund interests were submitted and accepted such that the applicable securities were acquired when the applicable investors were outside the U.S., those investors (and the related subscription amounts) would be excluded from the adviser’s assets and investors attributable to the U.S. even if, for example, the investors subsequently relocated to the U.S. (although future subscriptions or future acquisitions of securities would be analyzed by reference to the location of the investors at the time such subscriptions were submitted and accepted). The SEC has indicated that if an adviser reasonably believes that an investor or client is not "in the U.S." at the time that they became an investor or client then the adviser can treat such investor or client as not being “in the U.S.”14
"U.S. persons" are defined in Regulation S to mean persons who reside in the U.S. (regardless of their citizenship), not persons who are U.S. citizens. Therefore, for these purposes citizenship is generally irrelevant. However, Regulation S provides that, notwithstanding the principle that residency rather than citizenship governs U.S. person status, offshore offerings that are targeted at an identifiable group of U.S. citizens resident abroad will not be within the Regulation S safe harbor.15
Holding itself out. The SEC and its Staff take a very broad view as to what activities by an investment adviser/manager constitute "holding itself out to the public" as an investment adviser. Essentially, any marketing activities with respect to the availability of the adviser’s services to U.S. persons are considered to come within the definition, even simply letting it be known by word of mouth that the adviser is available to be retained.16 The SEC Staff views a person as holding himself out as an adviser if he advertises as an investment adviser or financial planner, uses letterhead indicating activity as an investment adviser, or maintains a telephone listing or otherwise lets it be known that he will accept new advisory clients, or hires a person to solicit clients on his behalf. 17
The Foreign Private Adviser Exemption is significantly narrower that the Private Adviser Exemption in that, along with the very limited asset threshold, it requires the adviser to "look through" private funds and count any U.S. investors in the fund towards the fewer than 15 U.S. clients and investors limit set forth in part (ii) of the test, although the adviser does not have to double-count the private investment fund as a "client" for this purpose. An adviser may be required to also "look through" persons who are nominal holders of a security issued by a private fund to count the investors in the nominal holder when determining if the adviser qualifies for the exemption. For example, holders of the securities of any feeder fund in a master-feeder arrangement may be deemed to be the investors of the master fund. However, an adviser may treat as a single investor any person who is an investor in two or more of the adviser’s private funds.
An adviser relying on the Foreign Private Adviser Exemption is not required to make any filing with the SEC.
Private Fund Adviser Exemption
For foreign private advisers who do not qualify for the Foreign Private Adviser Exemption and who manage only private funds with U.S. investors (no separate accounts with U.S. investors), the Private Fund Adviser Exemption may be more useful.
This exemption is available to an adviser solely to private funds, even with a place of business in the U.S., that has less than $150 million in assets under management in the U.S. For a non-U.S. adviser, this means that it will be exempt from Advisers Act registration under the Private Fund Adviser Exemption if: (1) all of its clients that are U.S. persons are qualifying private funds; and (2) all assets it manages at any place of business in the U.S.are solely attributable to qualifying private funds and have a total value of less than $150 million. "Private fund," "U.S. Person" and "place of business" have the same definitions as for a Foreign Private Adviser Exemption
Non-U.S. advisers can utilize the private fund exemption without regard to the type or number of non-U.S. clients or the amount of assets managed outside the U.S. Non-U.S. advisers are only required to count their U.S. clients and only private fund assets that are managed from a place of business within the U.S. Accordingly, a non-U.S. adviser is permitted to manage an unlimited amount of qualifying private fund assets provided its principal office and place of business is outside the U.S. and it does not manage any assets for U.S. persons other than qualifying private funds.
Non-U.S. advisers may not rely on the private fund exemption if it has U.S. clients in separately managed accounts. Typically an Alternative Investment Fund Managerwhich would provide along with its activities as fund manager discretionary portfolio management services for U.S. clients would not benefit from this exemption. In such cases, the only options available are the Foreign Private Adviser Exemption, or registration with the SEC.
Advisers relying on the Private Fund Exemption as well as the Venture Capital Exemption described below must still file reports with the SEC within 60 days of relying on the exemption. An annual update to the Form ADV must be filed within 90 days of fiscal year end.18
Venture Capital Fund Exemption
Finally, investment advisers to solely venture capital funds, regardless of the amount of assets managed, are exempt from the registration requirements of the Advisers Act as well. Thus, a single adviser that manages both venture capital funds and other types of funds cannot qualify for the Venture Capital Exemption. Unlike the private fund exemption, to benefit from the Venture Capital Fund Exemption, non-U.S. advisers may not disregard their non-U.S. advisory activities and all their clients, including their non-U.S. clients, must be venture capital funds.
A "venture capital fund" is defined as a private fund that satisfies the following conditions:
- represents to investors that the fund pursues a venture capital strategy;
- does not provide investors with redemption rights;19
- holds no more than 20% of the fund’s assets in non-"qualifying investments" (excluding cash and certain short-term holdings) (qualifying investments‖ generally consist of equity securities of qualifying portfolio companies‖ that are directly acquired by the fund);
- does not borrow (or otherwise incur leverage) more than 15% of the fund’s assets, and then only on a short-term basis (i.e., for no more than 120-days); and
- is not registered under the Investment Company Act of 1940 and has not elected to be treated as a business development company.
An adviser to a venture capital fund that is otherwise relying on the exemption could not (i) identify the fund as a hedge fund or multi-strategy fund (i.e., venture capital is one of several strategies used to manage the fund) or (ii) include the fund in a hedge fund database or hedge fund index. A venture capital fund is a private fund that represents itself as being a venture capital fund to its investors and potential investors, which implies that the fund invests primarily in operating companies and not for example in entities that hold oil and gas leases. Whether or not a fund represents itself as pursuing a venture capital strategy, however, will depend on the particular facts and circumstances. Statements made by a fund to its investors and prospective investors, not just what the fund calls itself, are important to an investor‘s understanding of the fund and its investment strategy.
What if a non-U.S. adviser does not qualify for an exemption?
Non-U.S. advisers conducting advisory business in or impacting the U.S. that do not qualify for any of these exemptions will have to register with the SEC as described below. However, before registering with the SEC, non-U.S. advisers might consider structuring their U.S. operations to minimize the U.S. regulatory impact by establishing a separate U.S. advisory affiliate and registering such affiliate with the SEC under the Advisers Act. Organizational separation of the U.S. advisory activities provides a greater degree of insulation between the activities if the U.S. registrant and the non-U.S. adviser. It also provides greater flexibility in addressing different or conflicting regulatory requirements that the U.S. may impose. The registration and other substantive provisions of the Advisers Act ordinarily should not apply beyond the separately organized U.S. registrant; while registering the non-U.S. adviser for its U.S. advisory business would subject the entirety of its global operations to U.S. regulatory requirements under the Advisers Act.
How does an investment adviser register under the Advisers Act?
In order to protect investors, the SEC has developed an extensive framework of disclosure requirements for investment advisers. Form ADV is the uniform form used by investment advisers to register with both the SEC and state securities authorities.
Form AVD consists of Parts 1 and 2. Part 1 is divided into Part 1A and Part 1B. Part 1A requires information about the investment adviser’s business, ownership, clients, employees, business practices, affiliations, and any disciplinary events of the adviser or its employees. Part 1 is organized in a check-the-box, fill-in-the-blank format, and is filed by the investment adviser electronically with the SEC. Although designed for a regulatory purpose, investment adviser filings of Part 1 are available to the public on the SEC’s Investment Adviser Public Disclosure (IAPD) website. Subsequently, the investment adviser is required to keep its Part 1 of Form ADV current by filing periodic amendments as necessary, as well as an annual amendment. Part 1B asks additional questions required by state securities authorities.20
Part 2 is also divided into Part 2A and Part 2B and is intended primarily for clients and includes information about the adviser’s services, background and qualification. Brochure Part 2A requires an adviser to prepare a narrative "brochure" that includes plain English disclosures of, among other things, the adviser’s business practices, investment strategies, fees, conflicts of interest, and disciplinary information. Part 2B requires an adviser to prepare a "brochure supplement" that contains information about each advisory employee that provides investment advice to its clients, including his/her educational background, business experience, other business activities, and disciplinary history. To satisfy the "brochure rule," the adviser must deliver the brochure (and updates to that brochure) to its clients annually and the brochure supplement about a supervisory employee to a client at the time the employee begins to provide advisory services to that client. In addition, the adviser must file its brochure, but not its brochure supplement, with the SEC to satisfy its registration requirements. The brochure will then be available to the public on the IAPD website. A non-U.S. investment adviser may limit this delivery to U.S. clients and prospective U.S. clients, subject to certain conditions.
Within 45 days after filing the Form ADV registration application, the SEC must grant registration or begin proceedings to deny it, assuming that the applicant has fully and properly completed all items of the form and accompanying schedules. The SEC Staff will return any Form ADV that is not fully and properly completed. A new 45-day period will begin when the Form ADV is resubmitted. Once the SEC has approved the Form ADV, the applicant may begin to conduct business as a registered investment adviser.
Is there a need to register with a U.S. State?
While non-U.S. advisers may avoid SEC registration under certain circumstances, non-U.S. advisers should be mindful of state registration requirements that may apply to the extent the adviser has U.S. clients. Accordingly, all non-U.S. advisers are encouraged to seek the advice of counsel with respect to state registration requirements. If a non-U.S. adviser registers with the SEC, it is exempt from registration with the States, although they remain subject to anti-fraud state statutes and may need to pay a "licensing" fee. If a non-US adviser receives an exemption from SEC registration, it may have to register with a State.
Fortunately, while each state in the U.S. has its own laws and regulations governing the registration of investment advisers, many advisers are ultimately able to avoid state registration in light of certain federal laws and regulations. The Advisers Act provides that no law of any state may require an investment adviser to register if the adviser does not have a place of business in the state and has had fewer than 6 clients during the preceding 12-month period who are residents of the state.21
What are the reporting and compliance requirements under the Advisers Act?
The Advisers Act’s regulatory requirements (which, except for basic anti-fraud provisions, do not apply to an offshore adviser’s relationships with its offshore clients) include, among others, the adoption and enforcement of a compliance program, a code of ethics (in a form largely prescribed by SEC rules), policies and procedures to prevent the misuse of material inside information, and policies and procedures with regard to voting portfolio securities that the adviser controls on behalf of U.S. clients.
What are the consequences of a failure to register?
If registration is required, the failure to register could have two types of potential legal consequences: (i) the risk of enforcement action against the unregistered adviser (and possibly against its officers, directors, or employees involved in committing the violations) and (ii) the risk of private damage actions against the unregistered adviser by its customers. Injury to reputation if the violation comes to light is also an important non-legal concern for many non-U.S. financial institutions.
The SEC has broad power to bring judicial and administrative actions against persons who violate the federal securities laws. In these actions, monetary fines could be imposed against the unregistered adviser and against the officers and employees who caused its violations. 22 Orders could also be issued barring the investment adviser and the responsible insiders from committing future violations. Any willful violation of the Advisers Act can also be criminally prosecuted. Criminal prosecution carries the risk that individuals who are found guilty will be imprisoned. For many non-U.S. institutions, the adverse publicity of being charged publicly by an agency of the U.S. government as a violator of the U.S. securities laws is at least as serious a problem as are the penalties and compliance orders that may result from the case.
In general, the U.S. securities laws treat transactions by persons or entities that are unlawfully unregistered as voidable at the option of the other party to the transaction. This would mean that customers could, in theory, sue to obtain a refund of the compensation paid for the advice in the case of an unregistered investment adviser.