On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), which significantly changes the landscape for investment advisers operating in the United States or taking investment from United States persons. Among other things, Dodd-Frank eliminates the “private adviser” exemption from the registration requirements of the Investment Advisers Act of 1940. Although most provisions of Dodd-Frank have a four-year phase-in period, provisions affecting private funds become fully effective in one year. As a result, investment advisers within and outside the U.S. must evaluate how Dodd-Frank will affect their business and determine whether they must register in the U.S.
Dodd-Frank’s impact on investment advisers is not limited to registration; other titles of Dodd-Frank alter the U.S. regulatory landscape for derivatives and swaps, and investment advisers using those instruments must also prepare for significant changes in these areas. Dodd-Frank raises a number of operational questions to be answered, in the future, by regulators, who must propose and adopt no fewer than 250 rules.
In an unusual twist, the U.S. Securities and Exchange Commission (“SEC”) has opened a special web page to receive comments on a number of rulemaking subjects Dodd-Frank requires the SEC to address.1 While regulators sort out the mechanics of organizing trading and clearing in swaps and derivatives, investment advisers can use the lead time to determine whether, and where, to register.2
No More Private Adviser Exemption
Title IV of Dodd-Frank, the Private Fund Adviser Registration Act, eliminates the “private adviser” exemption under the Investment Advisers Act of 1940 (the “Advisers Act”). Many private fund managers relied on this exemption to avoid registration under the Advisers Act. Under this exemption, an adviser with fewer than 15 clients during the preceding 12-month period did not have to register as an investment adviser with the SEC, so long as the adviser did not hold itself out to the public as an investment adviser. For counting purposes, the SEC considered a private fund as a single client (so long as the adviser did not otherwise provide individualized investment services to fund’s investors).
The SEC tried to eliminate this provision in 2004, when it required fund managers to look through to private fund investors when counting the number of clients they advise. The Court of Appeals for the D.C. Circuit, in the 2006 Goldstein case, rebuffed the SEC, throwing out the rule amendment, thus letting fund managers count their private funds as single clients. After the Madoff Ponzi scheme in 2008, conventional wisdom was that Congress would remove the private adviser exemption.
Adviser Registration after Dodd-Frank. Dodd-Frank replaces the private adviser exemption with a general requirement that an investment adviser to any private equity fund or other private pool of capital must register, with the SEC or with state regulators, but adds a few more limited exemptions.
Venture Capital Funds: Dodd-Frank exempts investment advisers who manage only “venture capital funds” from the registration requirements of the Advisers Act. What are “venture capital funds”? Dodd-Frank directs the SEC to define “venture capital fund” within one year of the enactment. Venture capital fund advisers must still comply with federal disclosure and record-keeping requirements (also to be delineated by the SEC in the next year). Venture capital fund advisers may still be subject to state adviser registration requirements. Whether the SEC will exempt indirect fund-of-venture-capital-fund managers is not clear.
In crafting a definition of “venture capital fund,” the SEC could look to other law for inspiration. For example, ERISA requires a “venture capital operating company” to invest a substantial portion of its assets in operating companies in which it holds and exercises “management rights.” Similarly, California requires a “venture capital company” or its principals to provide management assistance to portfolio companies.
The SEC might develop a new definition based on the research and development company exception contained in the U.S. Investment Company Act of 1940. It could also borrow from its own analysis of technology incubators.
U.S. private fund managers are watching this process closely. Some private equity fund managers and real estate fund managers are hoping that the definition of venture capital fund will cover their types of businesses. It is unlikely, however, that this exemption will cover all funds that formerly relied on the private adviser exemption.
Foreign Private Advisers: Dodd-Frank creates a new category of advisers exempt from registration for “foreign private advisers.” Foreign private advisers are investment advisers that (a) have no place of business in the United States, (b) have fewer than 15 clients or investors in the United States, (c) have less than $25 million in assets under management attributable to United States clients or U.S. investors in private funds managed by the adviser, (d) do not hold themselves out generally to the public as investment advisers and (e) do not serve as advisers to any registered investment company or business development company.
To count clients and assets under management for this exemption, foreign advisers must count individual investors in private funds, and their commitments to such funds (and not the drawn-down amounts), toward the 15 client/investor and $25 million thresholds. Generally, this exemption is not likely to cover many non-U.S. advisers that are actively seeking investment from U.S. sources of funding. The SEC, however, has the authority to impose a higher threshold for assets under management, which could make this exemption more useful.
It is not clear how far downstream the law requires advisers to look to determine whether an adviser has U.S. investors. For example, must a non-US adviser look through to individual investors in a non-US fund of funds that invests in a non-US fund? Master-feeder and hub and spoke structures hope the answer is no.
Presumably, other exemptions will be available to non-US advisers that do not qualify as Foreign Private Advisers.
Advisers Solely to Private Funds with Less Than $150 Million under Management: Advisers that only manage private funds and have less than $150 million in assets under management in the U.S. are also exempt from SEC registration under Dodd-Frank. Private funds are funds that rely on Sections 3(c)(1) or 3(c)(7) of the 1940 Act to avoid registration as an investment company. Advisers exempt from federal registration under this exemption will still be subject to federal disclosure and record-keeping requirements (to be delineated by the SEC). These advisers will also be subject to state adviser registration requirements; and if the adviser is currently federally registered, the adviser would register with the appropriate states and withdraw its SEC registration. If an adviser has a single non-fund account, this exemption is unavailable.
Other Advisers with Less Than $100 Million under Management: Investment advisers with clients other than private funds (e.g., separate accounts) will not be able to register with the SEC if the adviser has less than $100 million in assets under management and the adviser would be required to register with its home state and be subject to state examinations there. An adviser’s home state is the state of its principal place of business or principal office. Recognizing that multiple state registrations are burdensome, Dodd-Frank provides that if an adviser would be required to register with 15 or more states, then the adviser can register with the SEC. Advisers prohibited from federal registration under this provision will still be subject to federal disclosure and recordkeeping requirements to be prescribed by the SEC.
It is not clear how the SEC will define the extent of state oversight or examination that the SEC will deem adequate.
Family Offices: Advisers solely to “family offices” are exempt from SEC registration. Dodd-Frank directs the SEC to adopt rules to exempt “family offices” from federal registration, but there is no specific deadline; presumably, the one-year rule will apply. This new family office exemption is from registration only; family offices will still be subject to record-keeping and reporting obligations, and are specifically subject to anti-fraud rules.
Registered Commodity Trading Advisers: Advisers that are registered as CTAs with the CFTC and advise a private fund do not need to register with the SEC, provided that they do not predominantly provide securities-related advice. If the adviser begins to provide more than incidental advice about securities, it cannot rely on this exemption.
“Mid-Sized” Private Fund Advisers. Dodd-Frank requires the SEC to consider the size, strategy and governance of “mid-sized” private funds and their systemic risk in adopting rules requiring adviser registration, and tailor the registration and examination obligations to the systemic risk exposures. Managers of private equity funds, real estate funds and smaller hedge funds hope the SEC will adopt a new “Registration Lite” standard for them. Dodd-Frank does not specifically define “mid-sized” and post-Madoff, it is unlikely that “Registration Lite” will mean “regulation lite.” Based on the statute, however, “mid-sized” private fund advisers are advisers to private funds with between $25 million and $100 million under management; but the law authorizes the SEC to alter these thresholds by rule.
Expanded Record-keeping, Reporting and Disclosure Requirements
Dodd-Frank also imposes new record-keeping, reporting and disclosure requirements on all investment advisers. In most cases, state registered and private fund advisers, like current registered investment advisers, will be required to maintain records relating to their business activities. Dodd-Frank adds new, confidential reporting requirements. Virtually all advisers will have to disclose to the SEC information about their trading and investment positions and practices, and exposures that relate to systemic risks, e.g., assets under management, use of leverage including off balance sheet leverage, exposures to particular counterparties and types of securities, credit risk exposures, valuation policies, side letters and any other information the SEC and the Financial Stability Oversight Council (“FSOC”), the new systemic risk regulator, deems necessary and appropriate. The SEC is required to share information reports with the FSOC. A separate provision of Dodd-Frank, however, makes these filings with the SEC confidential and not subject to disclosure in response to Freedom of Information Act requests; and this protection carries over to any person who receives the information from the SEC.
Transition Period. Dodd-Frank’s registration requirements take effect one year after enactment. Generally, advisers that formerly relied on the private adviser exemption will be required to be registered by July 21, 2011. The SEC might extend this transition period, however, as it will take time for the SEC to define “venture capital fund.”
Requirements Applicable to Registered Advisers. Federal registration is significant, because the Advisers Act imposes strict requirements, which may involve considerable lead times. Even before Dodd-Frank, advisers were subject to strenuous record-keeping and compliance requirements.
Other Noteworthy Items
Revised Accredited Investor Standard: Dodd-Frank revised the definition of “accredited investor” in Regulation D of the Securities Act of 1933. For natural person investors relying on the $1 million minimum net worth standard, the value of the person’s primary residence is excluded. This provision became effective upon signing. Dodd-Frank directs the SEC to consider adjusting the net worth standard every four years, presumably to reflect inflation. Clients should consider whether they need to amend account opening or subscription documents, or offering materials, to reflect this change.
No Regulation D for “Bad Actors”: Dodd-Frank also requires the SEC to prohibit persons subject to certain discipline (state or federal) from relying on Regulation D. This rule will bar persons who have been sanctioned by a broad list of regulators, or convicted of a misdemeanor or felony involving securities, or involving the making of a false filing to the SEC.
13F Filers Will Report Short Sales: Dodd-Frank requires the SEC to adopt rules requiring Form 13F filers to report information about short sales of securities they report on Form 13F. This provision is intended to make public information about short sales of a company’s securities at any given time. The information will be collected and published monthly; the statute does not specify whether the institutional money manager will be identified by position, but presumably, the public disclosure will reflect all short sales by issuer.
Bank Sponsorship of Private Funds: Dodd-Frank also limits bank sponsorship or investment in private funds. Under the “Volcker Rule,” as adopted in Dodd-Frank, banking entities cannot acquire or retain ownership interests in or sponsor hedge funds or private equity funds, subject to a de minimis exception. Under the de minimis exception, a bank can keep an interest in a private fund, if this interest is less than 3% of the total ownership interests issued by the private fund at the end of its inaugural year, and the total banking entity exposure to all such funds does not exceed 3% of the bank’s Tier 1 capital. In addition, a banking entity can sponsor a fund only if the fund is available only to the entity’s banking customers, and meets other limitations.
Aiding and Abetting. Dodd-Frank changes the landscape of liability for “aiding and abetting” violations of law. Before Dodd-Frank, aiding and abetting liability required a showing of “knowing and substantial assistance” to the primary violator. Now, the SEC can prove aiding and abetting by showing “recklessness.” Dodd-Frank also amended the Advisers Act to make a person who aids or abets a violation by another person liable to the same extent as the primary violator, expanding the scope of fines and penalties under the Advisers Act.
What Should Fund Managers and Non-U.S. Advisers Do Now?
- Non-U.S. advisers immediately should assess the number of U.S. investors and level of assets attributable to them, and determine whether they will fall within an exemption. Advisers need to track not only the U.S. person status of their investors, but identify the home states of these investors.
- If assets under management attributable to U.S. sourced investors are between $25 million and $150 million, registration in some form (federal or state) is likely to be required. At this point, fund managers should consult their U.S. regulatory counsel to obtain guidance as to where the manager will likely be required to register, and to begin the risk assessment process and preparation of a compliance manual.
- If assets under management are over $150 million, federal registration will be required unless the adviser meets an exception, and the adviser should conduct an assessment of risks and policies and determine whether additional policies are required. In addition to conducting a risk-assessment and reviewing compliance policies, these advisers should also begin to review the “brochure” requirements, and review existing market materials with a view toward drafting the required brochure and Form ADV.
- Advisers to funds that rely on section 3(c)(1) or 3(c)(7) should determine whether they can rely on any other 1940 Act exclusion, and if not, consider where the adviser will need to register. These advisers should also begin to prepare Form ADV. Instructions to Form ADV provide significant guides and specific instructions about responding to Form ADV, including calculating the value of assets under management. The SEC released a revised Form ADV Part 2, including revised instructions, to be used after October 2010. State registration is also generally accomplished using Form ADV Part 1, and most states require the adviser to submit a completed Part 2.
- Fund advisers should also assess the level of managerial assistance, if any, that they provide to portfolio companies, and determine whether they have any sort of management participation rights (and whether they could get them).
- Advisers that are currently registered with SEC should review Form ADV and consider what additional disclosures, if any are required. These advisers should also determine whether additional policies are required to meet Dodd-Frank’s record retention and reporting requirements, and prepare to revise and file electronically Part 2. Registered investment advisers that have a fiscal year ending on or after December 31, 2010 will be required to file their annual update using the revised Form ADV (including Part 2 electronically) by March 31, 2011 and deliver a revised brochure to clients within 60 days after filing their annual update. For our separate memorandum on Form ADV Part 2, please contact a member of the Financial Services Group.