On December 11, 2009, the U.S. House of Representatives passed the “Wall Street Reform and Consumer Protection Act of 2009” by a vote of 223 to 202. The 1,279-page bill includes substantial changes added by amendment on December 10, 2009, and would bring about numerous reforms to the financial services regulatory system, including with respect to consumer protections, enhanced SEC regulatory authority, and regulation of entities perceived as posing systemic risks. The bill would enact, among other measures, the “Private Fund Investment Advisers Registration Act of 2009,” to amend the Investment Advisers Act of 1940 by requiring SEC registration of many currently-exempt private fund managers, including most private equity fund managers, as well as the “Investor Protection Act of 2009,” intended to strengthen investor protections for customers of investment advisers and broker-dealers. These reforms would, if approved by the Senate and signed into law by the President, establish significant new registration, reporting, recordkeeping, and disclosure requirements affecting many private funds and their advisers, and would impact advisers who are currently unregistered, as well as those who are already registered with the SEC.
Repealed Exemptions from Advisers Act Registration
The legislation would eliminate the “fewer than 15 clients” exemption under the Advisers Act, upon which many private equity fund managers currently rely to avoid SEC registration. In addition, advisers to private funds would no longer be able to claim exemption under either the intrastate exemption for advisers whose clients are all residents within the state in which the adviser has its principal place of business or the exemption for advisers registered with the Commodity Futures Trading Commission as a commodity trading advisor. Under the bill, a “private fund” is any fund that would be an investment company under the Investment Company Act of 1940, but for the exceptions provided under Section 3(c)(1) or Section 3(c)(7) thereof.
New Registration Exemptions under the Advisers Act
Certain advisers to private funds would be exempt from registration under the Advisers Act, including:
- Any investment adviser to a “venture capital fund” (to be defined by the SEC),
- Any investment adviser that “acts solely as an adviser to private funds” and has assets under management (AUM) in the United States of less than $150 million,
- Any investment adviser solely to small business investment companies licensed by the Small Business Administration, and
- Any investment adviser who has no place of business in the United States and, during the preceding 12 months, has had (i) in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser and (ii) aggregate AUM attributable to clients and investors in the United States in private funds advised by the investment adviser of less than $25 million (or such higher amount as the SEC may determine).
Venture capital fund advisers and private fund advisers with less than $150 million in AUM would have recordkeeping and reporting obligations as the SEC determines are necessary or appropriate in the public interest or for the protection of investors, while advisers to SBICs and exempt foreign advisers would be exempt from registration, reporting, and recordkeeping requirements.
Special Considerations for Non-U.S. Advisers
Non-U.S. advisers should be aware that, unlike in earlier versions of the legislation:
- The bill does not limit the definition of “private fund” to funds formed in the United States or to funds having a certain threshold of ownership by U.S. persons, and
- An adviser must count both its clients and private fund investors in the United States (and the aggregate AUM attributable to them) to determine whether it qualifies for the foreign private fund adviser exemption.
A non-U.S. adviser who does not qualify for the foreign private fund adviser exemption potentially may qualify for exemption from registration (but not reporting) if it acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million. The legislation does not define “assets under management in the United States” or address whether an adviser would be required to look through an offshore fund to include amounts invested by U.S. persons towards the $150 million threshold.
Advisers to “Mid-Sized Private Funds”
The legislation grants the SEC authority to provide for registration and examination procedures with respect to investment advisers to “mid-sized private funds,” taking into account the size, governance, investment strategy, and level of systemic risk posed by such funds. “Mid-sized private funds” are not, however, defined in the legislation, and it is unclear how this provision relates to the exemption for advisers with AUM in the United States of less than $150 million.
Reporting and Recordkeeping Requirements
All registered advisers would be required to maintain records and report to the SEC, on a confidential basis, regarding the private funds they advise as “necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk” as the SEC determines in consultation with the Federal Reserve Board. These records and reports would include, at a minimum, for each private fund:
- Amount of AUM,
- Use of leverage (including off-balance sheet leverage),
- Counterparty credit risk exposures,
- Trading and investment positions, and
- Trading practices.
The SEC could also impose additional reporting requirements as it deems necessary and, in making its determination, “may set different reporting requirements for different classes of private fund advisers, based on the particular types or sizes of private funds advised.” This rulemaking authority does not require that the SEC consult with the Federal Reserve Board, and leaves open the possibility that unregistered private fund advisers could become subject to SEC reporting requirements. In addition, the SEC would be empowered to require registered private fund advisers to disclose “such reports, records, and other documents to investors, prospective investors, counterparties, and creditors, of any private fund” they advise as the SEC “may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.” The SEC may not, however, compel disclosure of proprietary information (e.g., “sensitive, non-public information regarding the investment adviser’s investment or trading strategies”) to counterparties and creditors.
As discussed above, venture capital fund advisers and private fund advisers with less than $150 million in AUM that are exempt from registration would nevertheless be subject to recordkeeping and reporting obligations as determined appropriate by the SEC.
The SEC would be authorized to make the records and reports available to the Federal Reserve Board and a newly created Financial Services Oversight Council. All records of a private fund maintained by a registered adviser would be subject to periodic, special, and other examinations by the SEC.
Additional SEC Rulemaking Authority
Many details of the new regime are left open to the SEC’s rulemaking authority, which would be broad but not unlimited. For example, the SEC would have authority to ascribe different meanings to terms used in different sections of the Advisers Act, as it determines necessary to effect the purposes of the Advisers Act, except that the term “client” would not include an investor in a private fund managed by an investment adviser.
Requirements of Advisers Act Registration
Many unregistered private equity fund managers may be unfamiliar with the requirements associated with Advisers Act registration. These requirements include:
- Completing a Form ADV registration application (Part 1 of Form ADV, which is filed publicly with the SEC, describes the adviser’s AUM, ownership, basic operations, and past disciplinary events, and Part II, which is required to be delivered to clients and prospective clients, describes the adviser’s fees and investment program, and discloses conflicts of interest),
- Restrictions on marketing materials, including presentation of track record,
- Restricting the registered adviser’s ability to charge performance-based fees to persons who are not “qualified clients,” (the legislation would require dollar amount tests applied under this rule to be adjusted for the effects of inflation),
- Requirements for custody of client assets, including maintaining client assets with a “qualified custodian” and, in some cases, a “surprise audit” by an independent accountant and/or the preparation of U.S. GAAP audited financial statements of private funds,
- Adopting compliance measures, including implementing written compliance policies to prevent violations of the Advisers Act,
- Designating a chief compliance officer, and
- Becoming subject to routine and special SEC reviews regarding compliance with the Advisers Act.
Investor Protection Act
The Investor Protection Act included in the bill would establish various new requirements relevant to registered private fund managers, including that registered investment advisers maintain client funds or securities in excess of $10 million with an independent qualified custodian. The legislation also would create a specific fiduciary standard of conduct for investment advisers when providing personalized investment advice to retail customers, and would apply that same standard to broker-dealers. Although earlier drafts of the bill would have required that the SEC consider the need to establish a self-regulatory organization for the investment adviser industry (e.g., FINRA), this provision was deleted by the December 10, 2009 amendments.
Timetable; Next Steps
The bill is currently in the Senate, where it awaits examination and debate. In addition, the Senate will take up its own version of financial services reform legislation. In November 2009, Senator Christopher Dodd (D-CT) introduced a discussion draft of reform legislation that would exempt private equity fund advisers from SEC registration, and would expand recordkeeping and reporting requirements to cover side letters granting more favorable rights to investors. This discussion draft has reportedly been the subject of ongoing negotiations, and likely will undergo substantial modifications before a full vote in the Senate. Eventually the House and Senate versions of financial services reform legislation would need to be reconciled prior to passage of a final statute.
If the House version of financial reform legislation is enacted this year as currently proposed, private equity fund managers would not be required to register with the SEC before 2011, based on a one-year transition period. Nevertheless, while the final parameters of financial services reform, and the ultimate burdens that will be imposed on private equity fund managers, remain in flux, it is likely that private fund advisers will become subject to, and should consider preparing for, some form of registration requirement in the future.